The scale of the European debt crisis is large, as is the investment opportunity.
In commercial real estate-related debt alone, European banks have around €960 billion on their balance sheets (CBRE Research 2011). With tailored structuring and asset management solutions, as well as appropriate writedowns, much of this debt could be transformed into an exciting opportunity for institutional investors seeking attractive returns, Forum Partners believes.
The two largest European markets, the UK and Germany, account for more than half of the outstanding commercial real estate debt in Europe (see Figure 1). Data for the UK shows that the commercial real estate debt market has grown significantly in the past decade. According to a survey by Capital Economics, outstanding commercial mortgage debt rose from just under £50 billion in 2000 to approximately £250 billion in early 2008 during the peak of the market. Since then, outstanding debt has only fallen by approximately 10%, reflecting writeoffs, loan repayments and amortisation. This issue has been exacerbated by the slower pace of new lending.
Effects of the financial crisis
The financial crisis and the bursting of the liquidity bubble left banks with a number of problems related to their commercial real estate lending and the underlying property markets. These problems included overleveraged assets, a mispricing of risk and a steep fall in capital values.
Using data from economic and property analysts, Forum has estimated that the typical UK commercial asset fell in value by just over 34% from the peak in 2007 through to the end of 2011. Capital Economics believes that values will fall by a further 5% over the next three years, leaving the average UK commercial asset sitting on a 39% peak to trough decline. These hypothetical losses, while severe, may even understate the extent of losses incurred when resolving impaired assets if one takes into account transfer taxes, transaction expenses, hedging break costs and other related costs.
In the middle of 2011, there was a common market perception that European banks would be able to resolve their problems without needing significant outside capital or government assistance.
The prevailing rationale was that financial institutions had identified their problem assets, understood the magnitude of the associated losses and had hired sufficient personnel to address their issues. In addition, regulators seemed comfortable with provisions against bad loans. Property markets appeared to have stabilised after a volatile period of price declines and a general sense pervaded the industry that banks’ problems would sort themselves out over time.
Anecdotal evidence, such as the issuance of Deutsche Bank’s Chiswick Park securitization (the first true European commercial mortgage-backed securitization in years), gave investors hope that the capital markets would reopen, providing much-needed liquidity to the real estate debt markets.
The crisis deepens
The economic crisis in Europe, however, has worsened in the past year and a number of large overleveraged economies demonstrate weak growth prospects. In the face of these issues, property markets are expected to weaken even further despite improved supply/demand dynamics driven by lower construction volumes.
While covenants and maturities on many loans have been waived, extended and/or restructured, many are still not performing as expected. A UK banking survey by De Montfort University revealed that approximately 9,770 commercial property loans in the UK alone were in breach of financial covenants in 2011. The total principal amount of such loans grew from less than £1.6 billion in 2007 to nearly £28.3 billion by the end of 2009. The tide of loan delinquencies appeared to crest in 2009. However, the volume of such impairments has begun to pick up again, reflecting a souring macro economy and the difficulty faced by borrowers in refinancing existing loans.
In addition, asset management issues (including unfulfilled capital expenditure needs) are now having a material impact on performance and value. This is particularly the case with secondary and tertiary assets that have been hardest hit by a flight to quality. While markets such as Ireland and Spain have been struggling with the property albatross around their necks, cracks are beginning to show in other markets too, such as France and Germany, which were once thought to be much healthier. Regulators have become increasingly concerned about the carrying value of loans held with banks and the banks’ abilities to fix problem loans.
New regulations are being discussed that would potentially require banks to reassess internal models to measure risk. According to a study commissioned by Boston Consulting Group, European banks need to raise €345 billion in new capital or reduce risk-weighted assets (RWA) by €5 trillion–€7 trillion. Given the state of the capital markets, this will prove extremely difficult without state support.
As an alternative, Forum has evaluated structures that reduce RWA (and thus the amount of this equity funding gap) through a variety of ‘true sale’ and deconsolidated off-balance sheet transactions. Forum’s analysis suggests that, in certain circumstances, it can potentially generate up to 58 cents of RWA relief per euro of assets contributed into such structures.
Other factors for fewer refinancings
The commercial real estate lending market largely collapsed across Europe at the end of 2011, as banks were forced to shrink businesses in the face of more stringent capital requirements, underfunded equity bases and a large-scale sovereign debt crisis. This put increased pressure on the ability of borrowers to refinance existing loans, which, in turn, prevented banks from further reducing the volume of impaired loans on their balance sheets.
According to property adviser DTZ, the European debt funding gap – the amount of new debt capital needed to fill the gap between future loan maturities and available bank refinancing – reached US$122 billion in November 2011.
The collapse of the lending market has substantially impacted the availability of third-party financing for banks working on loan portfolio sales. It has made vendor financing effectively the only option for sellers seeking to transfer risk and deconsolidate risk-weighted assets.
Given the desire to reduce real estate exposure, banks are reluctant to offer vendor financing and will only do so as a last resort. When offered, the cost and terms of this financing have a significant impact on overall deal economics and risk profile. These include the cost of debt, facility duration, amortization provisions and covenants.
Opportunity for private equity
Recent large portfolio trades, such as the £1.36 billion RBS/Blackstone Project Isobel transaction and the £900 million Lloyds/Lone Star transaction, have received extensive press coverage. However, billions of distressed loans have traded since 2007 in the form of one-off transactions and portfolio trades.
The majority of these transactions have been either off-market or private transactions that have not been announced to the public but are known within the industry. That said, the prospects for future volumes are far more exciting. It is believed that the European opportunity could be as large or larger than the US Resolution Trust Corporation deleveraging in the 1980s.
This prospect has brought US firms to Europe in search of opportunities and has mobilized European players. Many of these buyers have faced significant challenges in Europe. Some firms have a limited number of professionals on the ground or do not have the integrated asset management and loan-servicing platform required to effectively capitalize on the opportunity. Other firms lack the track record in European real estate debt investing or the appropriate sourcing network and can only compete on large ‘on-market’ transactions. Notwithstanding the strong interest among real estate private equity firms in the European opportunity, industry observers believe that there is insufficient equity capital relative to the size of the distressed debt opportunity.
Bridging the finance gap
The current unsustainable situation calls for investors with the necessary capital and ability to work with financial institutions to deliver three broad categories of solutions: asset management, balance sheet and organizational solutions. Asset management solutions address issues of capital needs, cash flow deficiencies, poor asset performance and the inability to refinance in the current market. Balance sheet solutions include congested balance sheets, unrealised losses, high regulatory capital charges and funding challenges. Organizational solutions address human capital issues, as banks seek to downsize or exit business lines that are no longer a strategic fit. These issues include excessive headcount, overhead costs and employee retention.
Forum believes that the successful delivery of these solutions requires an integrated platform of experienced professionals and operating partners who possess the technical skills, experience and footprint to create bespoke structured joint ventures with banks. These joint ventures accomplish the banks’ objectives and deliver superior risk-adjusted returns to investors by unlocking asset value. An integral part of these solutions is controlling a servicer with the ability to coinvest alongside the equity to create true economic alignment with investors.
Over the past four years, Forum has built a fully integrated European debt platform and has been involved in a number of transactions that will be the forerunners of a new and exciting reordering of the real estate market in Europe.
The severity of the European debt crisis is rivaled by the opportunity that it presents to dedicated real estate investors who have the capital and expertise to deliver asset management, balance sheet and organizational solutions to assets and banks. While uncertainty pervades the European distressed debt landscape, the opportunity for groups such as Forum to generate superior risk-adjusted returns is among the most attractive in private equity.