ECB rescue has only postponed deleveraging, delegates at CREFC event say. Jane Roberts reports
Funding was becoming expensive and restricted again for banks late last year, but the €1trn or so of cheap money sloshed out by the European Central Bank in its recent long-term refinancing operation (LTRO) seems to have given them a breathing space.
At the Commercial Real Estate Finance Council Europe’s Spring conference, held on 27 and 28 March at K&L Gates’ new St Paul’s headquarters, bankers such as Matt Webster, global head of real estate financing at HSBC, and Richard Heath, Lloyds’ head of corporate real estate, said the ECB’s three-year, 1% finance had relieved banks’ funding pressures – in the short term, at least.
But the debt buyers attending, including Lone Star and Blackstone, and banks seeking to lend to debt buyers, such as Goldman Sachs and Deutsche Bank, hoped the release of pressure on banks wouldn’t slow down their real estate deleveraging too much.
Deutsche Bank’s Don Belanger was just one who wanted to see more. “There were four non-performing loan portfolio sales in the market in October – more than at any time in the previous three years,” he said. “Now they have gone through the process there haven’t been any new, large portfolios for sale. The frustration for a lot of us who are buying or financing these portfolios is they are not coming out quickly.”
Webster said the infusion of LTRO money might lead some lenders to cancel asset portfolio sales planned last year to raise liquidity. He reminded delegates that at the end of 2011, banks faced two critical issues: liquidity/funding and bank capital pressures.
The LTRO has removed pressure for fire sales and bought the banks some time, allowing for more orderly deleveraging over a longer period (see fig 1, below). But Webster added: “LTRO hasn’t changed the issue in terms of the amount of assets still on balance sheets and there will still be the debt refinancing risk coming through.”
Up to €1.5trn of deleveraging to come
HSBC’s estimate of the asset deleveraging in coming years for the European banking sector is €1tn-€1.5tn. “This gives perspective to the €1.02tn of LTRO liquidity,” he said.
New capital rules require banks either to hold more core tier 1 capital or reduce risk-weighted assets on their balance sheets. In practice, Webster showed, they plan to do both (see fig 2).
The European Banking Authority’s aggregate assessment of banks’ submitted plans to increase their capital buffers to 9%, published in February, shows 23% of proposed solutions focus on cutting risk- weighted assets, with asset disposals accounting for 7%. The other 77% is direct capital impact measures, such as conversion of hybrid equity to equity (see fig 3).
One of the big four accountants present at the conference is advising banks that need to shrink their balance sheets, particularly in Ireland and Spain. A director of the firm pointed out that it takes time to prepare big portfolios for sale and said his team is being invited to pitch, so there will be more sales.
However, a refrain over the two days was that the bid-ask spread between banks and prospective buyers is too wide and is holding up deals or has caused some to be pulled.
Speakers from Royal Bank of Scotland in particular viewed private equity buyers’ costs of capital as usually too high. They pointed out that the safety net of the Asset Protection Scheme meant the bank is not under pressure to sell at a loss. RBS can also sell assets to its West Register vehicle, giving the bank a floor on pricing.
But the handful of institutional buyers with a lower cost of capital who were there, such as M&G Investments director Peter Foldvari, said they are hunting for perform-ing loans, rather than non-performing loan portfolios bought with a view to owning the underlying assets, or other investment angles.
Others agreed that talks about debt sales are continuing behind the scenes. Private equity firm Lone Star has bought portfolios from various European sellers recently. Lone Star MD Jordi Goetstouwers Odena said: “We always hear that deals aren’t happening, but the cost of capital argument is a red herring; it isn’t the magic ingredient; what is offered for sale is.
Finding angles to add value
“The trick is to find something where the buyer has an angle to add value or has a more optimistic view on the timing of realising [the loan]. Negotiating is a long process and it is going on behind the scenes.”
There was advice from various quarters about packaging loans to get the best possible price. Documentation should be clear but not overwhelming in quantity, said James Katchadurian, executive vice-president of US firm EPIQ, which advised Anglo Irish on due diligence for the sale of its $10bn US real estate loan book. Vendor financing also helps sharpen the pencil, added several speakers.
Where third-party debt is sought, lenders are “extra picky about what they finance in today’s environment”, said Goetstouwers Odena. “If a buyer wants to be able to buy at a full price, the seller has to deliver a clean asset. Someone has to be paid to do that; it can be a buyer or a seller, but it is time-consuming and there is risk.”
The conference’s other hot topic was availability of finance. Attendees agreed that debt is available for good-quality property and from a select band of international banks for loan portfolios; but not the secondary property underpinning the wall of loan maturities. CBRE director Natale Giostra said some tertiary property “you can’t underwrite at even 10-15% loan to value”. Simon Dunne, a director of Savills Capital Advisors, and Anil Khera, a principal at The Blackstone Group, said the lending market is now much more fragmented.
“You used to know where to find debt and at what cost, but there is a lot more legwork involved now,” said Dunne. Khera added: “Sponsors are sometimes more important to lenders than assets and those borrowers are seeing the upside now, because banks will lend to them, but others are being left behind. You need more creativity to finance deals. For example, we have used joint venture partners’ balance sheets, longer-term fixed income products and securitisation to finance Chiswick Park. A lot of effort goes in early on how we will price each structure.”
Availability of finance may improve as more shadow banks and insurers aggregate capital and get set up to invest in debt, thus introducing some competition and improving liquidity a bit.
“More liquidity coming in will push people towards secondary assets – at some point,” said Peter Hansell, head of Cairn Capital’s property group. Everyone felt this time was creeping closer, but that the disintermediation of the banks will continue to be slow. A side issue raised was regulation of non-bank newcomers – and how uneven the playing field will be in future for banks. DTZ head of research Hans Vrensen asked: “Why should a bank have a different capital treatment to an insurance company for making the same loan?”
Meanwhile, borrowing costs will keep on rising and in the UK, slotting (the requirement for banks to slot loans into set risk categories) will push costs up further, said the UK banks present. This should play into the hands of newcomers to senior debt investing who, said Giostra, will be looking for 4-6% returns “so will have to lend at margins of 350-400 basis points”.
RBS explores the alternatives to debt disposals
Debt sales are just one option for banks that need to shrink their balance sheet to release capital, as several of the UK banks at the conference pointed out.
Rajesh Sivaraman, a managing director at RBS who worked on the Project Isobel loans transferred into a joint venture with Blackstone, said RBS has sold businesses, run off loans – largely through non-renewal of maturing facilities – and taken some impairments. “Our book in France went down 30% just by refinancing with French banks,” he revealed. “Around 50% of our decrease has been through run offs.”
Sivaraman said that in real estate, where sales are considered, the high costs of capital of some debt providers plus the more liquid market for direct assets means RBS often prefers to sell the property, rather than sell the loans, where possible. It may also be easier to get financing for properties rather than debt.
Steve Clegg, a senior director in the global restructuring group, said RBS is on target to eliminate its non-core real estate book by 2013. On 23 February the bank announced with its 2011 results that it had reduced non- core assets from £42bn to £31bn and its overall property book from £90bn to £76bn.
“The asset protection scheme has been key as it has given us time, so we are not seen as a forced seller, though people may say it is an artificially low cost of capital,” Clegg said. “There is a discount for portfolio sales but the advantage is you clear the balance sheet in one hit. We have been most successful at restructuring deals so existing owners can sell, and standing behind them.”
CREFC provides guides to a fragmented European lending landscape
The CREFC is producing a series of guidelines this year, partly in response to fragmentation of property lenders into different types. The first two, on good lending practice and real estate lending tax issues,were launched at the conference. Four more will cover the evolution of CMBS; hedging; inter-creditor agreements; and due diligence best practice.
Peter Denton, CREFC Europe lender committee chairman and head of UK lending at BNP Paribas, said: “Europe is seeing a fragmentation of lender types – not just balance sheet-using banks and capital market issuers, but the appearance of a more mature subordinated debt market. Interest from new entrants such as insurers, pension funds and money managers is also growing. These are good reasons to focus on market standards.
The CRE lending tax guide, produced with Ernst & Young, sets out common issues prospective lenders should consider in their decision-making for property lending. The 19-page European commercial real estate lending principles covers loan structuring and documentation and concisely pinpoints issues that have arisen from managing the fall-out of the credit crisis and incorporates knowledge gained into a set of recommended best practice guidelines.
As the introduction says: “The crisis of the past few years has meant lending practices have been rigorously tested and significant insight as to their robustness gained.”
Issues covered in the lending principles and highlighted by Denton in a session on ‘standardisation’ at the conference include default margins previously applying only on payment defaults. This is a problem, as banks’ capital costs rise significantly after any default under Basel II or III. An alternative structure being tried is an LTV/ICR margin grid where a default triggers the highest margin.
Funding special-purpose vehicles rather than underlying assets has been problematic. Denton said banks have sometimes funded SPVs when they thought they were funding properties. If things go wrong, the costs are usually higher. The paper says lenders should look at corporate-level net operating income, not net rent in these cases. They should be aware that in the case of enforcement, creditors have been unable to enforce and sell the borrower SPV as opposed to the asset(s).
This can be compounded in cross-border deals. Offshore vehicles may own or manage UK property, as happened with the White Tower securitisation, where the vehicle was in the Channel Islands. The paper says the lender’s lawyers should provide clear written advice on the potential enforcement impact of any cross-border structure.
Other lessons relate to financial covenants, such as some deals having no consequences for covenant breaches, while others “often have a simple covenant breach point that moves the deal straight from ‘performing’ to ‘default’”. The paper says temporary curing of breaches should be rare, “to avoid prolonged artificial maintenance of a deal”.
Hedging is covered briefly. Conor Downey of law firm Paul Hastings said ranking and security between lenders and swap providers is a big issue: “We are seeing swaps’ super-senior position under attack, especially from German banks.” The paper says there is no market standard on swap termination rights. These issues will be addressed in more detail in a forthcoming loan hedging paper.
The lending principles paper observes other practices that are evolving; for example, prepayment fees, where some non-bank lenders, presumably insurers, “are starting to advocate ‘margin make whole’ provisions for a certain number of years”.
The CREFC paper was produced in tandem with the Loan Market Association’s real estate finance facility agreement and each body was represented on the other’s working party. The LMA 200-page facility agreement, published on 16 April, sets out how to document a deal. Denton said the aim of the CREFC paper was “to encourage lenders to ask the right questions rather than give all the answers”. Both are advisory only.