The sale of a jumbo pool of legacy Spanish real estate loans written by Commerzbank unit Eurohypo is just the latest evidence that the long-awaited deleveraging of Europe’s banks is set to accelerate. But as demand and supply in this part of the market finally align, the careful timing of sales will be crucial to their success. The German bank is in the market with a €5 billion portfolio of performing and non-performing Spanish real estate loans, the largest jumbo commercial real estate loan sale by a foreign lender since the crisis.
Commerzbank is being advised on the sale, dubbed Project Octopus, by Lazard. Around €3.3 billion of the pool is understood to be performing, with over €1 billion non-performing. Although the deal is being hailed as evidence of the recovery in Spain’s commercial real estate sector, it is also very much a product of the seller’s particular circumstances.
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| David Edmonds, partner at Deloitte |
“The Eurohypo sale is part of a wider strategy by a number of global banks to withdraw from certain geographical markets, so it might not indicate a broader trend in the Spanish market,” says David Edmonds, partner at Deloitte in London. Commerzbank exited the UK lending market in July last year with the sale of a £4 billion ($6.6 billion) portfolio of CRE loans to Wells Fargo and private equity firm LoneStar.
“Spain has been in the market for the last five years but mostly only for written-off consumer debt, as that is all the Spanish banks could afford to sell,” says Edmonds. “The establishment of Sareb [Spain’s bad bank] means that real estate portfolios are starting to emerge.
Commerzbank has already sold a separate portfolio of €710 million of Spanish CRE loans this year. Sareb sold its first portfolio last August, a pool of 939 repossessed properties formerly held by Bankia that was bought by Bayside Capital, an affiliate of Miami-based private equity firm HIG. This was followed by the sale of a €245 million portfolio of loans to property developer Colonial to Burlington Loan Management, a unit of hedge fund Davidson Kempner Capital. In November, Sareb sold two portfolios of loans valued at €232 million to Deutsche Bank.
There were €30.3 billion CRE and real-estate owned sales in Europe in 2013, 89% of which took place in the UK, Ireland, Germany and Spain. According to research published by PwC in March, €64 billion of non-core loans were sold in Europe last year, with €80 billion of sales forecast for 2014. The combination of the chase for yield and anticipated selling pressure stemming from the European Banking Authority’s asset quality review (AQR) later this year is behind this sharp rise.
“The focus is now around the periphery – Italy, Spain and Greece,” says Duncan Priston, head of European corporate distressed and special situations at Bayside Capital. “The AQR and provisioning now becoming more appropriate means that banks are offering to sell assets at more attractive levels. These jurisdictions are, however, more problematic than the UK and Ireland where the path to value is much clearer.” PwC estimates that banks across Europe are still holding loan assets of €2.4 trillion that they regard as non-core. In January 2013, Morgan Stanley estimated that European banks had sold or refinanced 20% to 25% of the €700 billion NPLs they needed to deal with to meet regulatory capital requirements.
EY reckoned that NPLs were due to peak at €932 billion (7.6% of total loans in the euro area) in 2013 and drop to 5.6% in 2014. Intense interest Investor interest is now intense. Richard Thompson, partner at PwC, reveals that the firm is now in contact with over 150 investment groups looking to invest in the European market. In March, Pimco revealed that it has raised $5.5 billion for its Bank Recapitalization and Opportunities II Fund (Bravo II), which will target non-core assets on US and European bank balance sheets. The firm raised $2.4 billion for its first Bravo fund in 2011. It joins a short list of large, US private equity and distressed fund buyers that are dominating this space in Europe. They are led by Texas-based LoneStar, which has been in the European distressed market for years and has seemingly appeared on the bid list for every deal so far, together with such firms as Apollo, KKR, Oaktree, Cerberus Capital, Colony Capital and Fortress.
“The deleveraging has begun in earnest,” says Ahmed Hamdani, head of European non-corporate distressed and special situations at Bayside Capital. “One year ago you would ask why you were not invited to bid on something; now you don’t have the bandwidth to look at everything that is coming out.” The sheer volume of money chasing these deals does not, however, mean that the expected volumes will automatically get done. “We saw a significant influx of new capital into Europe in 2013 but it is too early to tell what the impact will be – we will know more this year,” says Ian Cosgrove, partner at EY. “It is not clear whether the new influx of demand has the operational capacity underneath it to transact the volumes required. There are an awful lot of portfolios now out there for sale and the market will have to address the issue of capacity. The constraint is now less about capital and more about the sheer capacity to transact assets and work them onto platforms.”
European regulations covering risk retention (whereby the issuer of a deal must retain 5% of outstanding risk) are also causing a headache for some buyers. Many private equity buyers finance sales via both bank debt and equity. If they fund their equity portion using subordinated debt this can cause the deal to be treated as a securitization by the regulators. "The risk retention requirements are difficult to adapt for certain structures," says Salim Nathoo, partner at Allen & Overy in London. "The definition of securitization is very broad and includes any tranched exposure, which has the potential to capture certain bank lending structures. If the financing for a portfolio acquisition involves both senior and subordinated debt this is treated as a tranched exposure and the risk retention rules apply. Private equity buyers are usually willing to take risk retention but are not always eligible to hold the required retention under the rules. Finding a suitable holder has been a challenge for some of these deals."
The cost and complexity of servicing NPLs means that the larger buyers have the upper hand for these loans and the concentration of the market in a few big players’ hands is striking: 50% of the $60 billion that has been raised for this strategy in the past 18 months sits in 10 to 12 funds. Edmonds points out that while Deloitte sold 30 portfolios worth €50 billion across 12 countries in 2013, the list of ultimate buyers was only seven or eight institutions long, despite interest and participation from over 40 funds. The pipeline might finally be there for Europe’s distressed-debt buyers, but the market is unlikely to be as lucrative as they first hoped because of the sheer weight of money now chasing the trade. Analysis of European CRE loan portfolio pricing published by PwC last year found that investor expectations for non-performing CRE loan discounts were 50% in 2011, 63% in 2012 and 54% in 2013. “While distressed debt spans the capital structure, we believe the most attractive opportunities can be found in senior secured debt, where it is priced at a discount to terminal par value,” says Ian Burnett, head of distressed debt at BlueBay Asset Management. Commerzbank’s sale of its UK loan book is understood to have been at a 3.5% discount to book value.
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Thanks to the weight of demand for such loans, UK CRE-backed unlevered returns are now in the high single digits where three years ago they would have been in the high teens. Unlevered CRE returns in Spain are low to mid-teens while in Ireland investors can expect unlevered returns of between 10% and 12%. No thrills Speaking to Euromoney in March last year, Oaktree Capital Management chairman Howard Marks revealed that the returns on offer from European distressed investing were not what the firm had expected in the early years of the crisis. He said he would be “thrilled” if Oaktree made a return in the teens on these investments now. Oaktree, together with Cerberus Capital, and LoneStar, was understood to be bidding for the £914 million Irish Bank Resolution Corp (IBRC) Project Salt portfolio, which together with the £3.94 billion Project Rock was sold by the liquidator KPMG at the end of February. LoneStar cleaned up on the sale, taking the lion’s share of the pools, with just two loans going to Sankaty Advisors and Canyon Capital.
The funds are understood to have paid around €5 billion for the portfolios, a discount of around 30%. Pimco is understood to have approached Nama for RBS’s entire €4 billion portfolio of Northern Irish loans. The usual suspects are believed to be bidding for Nationwide’s €850 million German CRE portfolio, led by LoneStar, Apollo, Pimco, Oaktree and Fortress. Just how much dealflow is triggered by the AQR is critical to how the strategy will fare this year. “The AQR will without a doubt cause a great shake-up,” predicts Edmonds at Deloitte.
“The requirement to mark NPLs to more reasonable levels together with the treatment of loans that have been subject to forbearance will be very important. If they are now forced to be held as NPLs it could trigger a lot of selling by the banks. If, for example, you are a mid-tier German or Italian bank your route to capital is very limited. These institutions will have to start selling assets.” Putting a figure on just how many assets is still fiendishly difficult, however. “It is too early to tell how many assets will come to the market as a result of the AQR,” Edmonds concedes. “But even if the current €1 trillion of NPLs in the EU financial sector increases by 20% to €1.2 billion and trades come at 40c to 60c in the euro then demand and supply should still be quite evenly balanced.” The nature of the pipeline will be consequential. If large pools of maintenance-heavy assets come up for sale in very quick succession there could be questions over the market’s ability to digest them efficiently. “There is so much volume now that if there is more activity as a consequence of the AQR and stress testing it will strain capacity,” warns Cosgrove at EY.
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