Asset sales may be only way to defuse the debt time bomb

ULI report respondents see more opportunities ahead to buy secondary assets, writes Lauren Parr

The real headache is only just about to start for banks, given the “ticking time bomb” secondary property represents. This is the conclusion of more than 600 investors, developers, property companies, lenders, brokers and consultants surveyed for the Urban Land Institute’s and Pricewater-houseCoopers’.

While almost a third of Europe’s €960bn of outstanding commercial property debt is secured against poor-quality property at high loan-to-value ratios, by CB Richard Ellis’s estimates, banks are only part-way into the Herculean task of dealing with the debt (see ‘European property debt maturity’ chart below). But pressures from the likes of the forthcoming Basel III capital reserve rules mean they will have to face up to the worst problems sooner or later.

Capital is almost entirely focused on core assets in major cities such as London and Paris, where tenant demand will remain robust, while the report identifies Dublin, for example, as a city that will be deserted by investors.

As a result, the gap between prime and secondary property will widen. “The issue is that the banks are sitting on a vast quantity of stuff that’s becoming less valuable as each month passes,” says one of the authors, PwC real estate funds partner John Forbes.

The catch-22 situation banks face is that it is impossible to sell these properties without taking a massive loan loss, but it is also very difficult to hold on to them; the short leases, low-quality assets and need for capital expenditure means their value is unlikely to rise before the loan matures.

Investors seek deep discounts

For deals to clear, prices will have to fall, because the investors that are interested in  secondary assets want deep discounts, both due to lack of debt availability and their requirement for prices to reflect the risk they would be undertaking. Those willing to take on “truly obsolete properties that valuers just drove by quickly and hit a value that made the deal work”, as one interviewee put it, will be very rare.

With values set to continue plummeting for secondary assets, the market could work in investors’ favour. Another respondent  to the report said: “An ‘exciting’ moment will come later this year in the UK when the spending cuts come in, unemployment rises and maybe interest rates rise a little bit. Secondary properties will come onto the market and values will have to fall to a level where you can buy assets with just equity and still make a sensible return.”

“The question is, who is going to respond? There aren’t many secondary players with capital to play with like that.” Other secondary market opportunities include buying better-quality property when it is discounted to prime. “When markets recover, so will good-quality secondary,” said another respondent. “The market reclassifies what is prime and blurs secondary, so if you can, buy that stock cleverly with the right sort of yield discount.”

There is also an opening for investors seeking higher returns to invest in non-core assets that can be repositioned, says Forbes, for example by addressing a tenant issue or improving a building: “There’s continuing interest in the core market, but to me this represents the most interesting opportunity.”

Expected fire sales by banks have not materialised, despite what last year’s report called a “huge problem coming over the hill”. But there is still no magic solution for refinancing the mountain of debt nearing maturity. “The only thing that’s changed since last year is that it’s a year closer,” says Forbes.

The report, released in February, suggests that the global debt funding gap will remain the elephant in the room for 2011. DTZ estimates this gap to be €183bn between 2011 and 2013, with Europe having the greatest exposure to that, at 51% (€94bn). Ireland, Spain and the UK face the biggest problems relative to their market size.

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But small steps are being taken to tackle these issues and shift distressed properties into the market (see pp20-21). DTZ records that sales by administrators had already doubled to 47 in the first three quarters of 2010, compared with the whole of 2009.

Respondents were largely interviewed in November, when some already reported a gradual rise in opportunities to buy distressed property from UK and German banks, and from the Irish state’s National Asset Management Agency (NAMA).

“In the past four to six weeks, properties have come to us from administrations, and there are rumours of more coming,” said one respondent. “I think we will see more interesting opportunities from the banks in 2011. They have put teams together and have seen a recovery in underlying values, and are now prepared to move things out.”

Opportunities with Spanish syndicates

Another respondent said working with Spanish banks on restructurings could be an attractive proposition. “There are a lot of syndications in Spain with overseas banks, and these syndicates have heavy restructur-ing to do. Some can’t do that, so they want out. Slowly things will get undone and these banks will exit these countries.”

Not everyone shares this view, as some believe that getting deals out of the banks is a local game. One interviewee said: “In Germany, the locals are well tied into German banks and are starting to cherry pick individual deals where banks do not want to foreclose. But for the British to knock on the door trying to talk about a problem loan portfolio, that is hard.”

Investors remain frustrated by their inability to access more deals at bigger discounts, but the bankers interviewed put this down to unrealistic price expectations. One respondent said: “The problem is that clearing prices for legacy loans are substan-tially discounted against where banks are carrying those loans, so the losses they have to take on good assets is material. Banks will start moving stuff, but they can’t afford to take capital losses, as they will go bust.”

It was also noted that banks and NAMA do not want to be seen to deal with people perceived to be exploitative or opportunistic. In addition to the refinancing problem, which goes hand in hand with the amount of new lending banks can provide, financial institutions also face the pressure of new regulation. Basel III measures will not  come into force for some time, but are already having an impact on lenders in the form of a reduction in new business.

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Pfandbriefbanks “step backwards”

“The pfandbrief banks have taken a step backwards,” one interviewee noted. “There are more French banks lending than German banks. Irish, UK, Italian and Spanish banks are lending zero. One or two Scandinavian banks will lend on a £30m deal, but no more. It is very hard to find senior financing today.”

Interviewees also voiced concerns that  German banks would completely withdraw from property lending as a result of Basel III. An employee of one German bank admitted: “In the past couple of years, the liquidity that existed depended on German banks. Basel III has been a big thing; every bank is being audited on how it allocates capital and what that means under Basel III.

“Some European banks are being given three years to get to the ratio the regulator wants, but the German regulators are saying, ‘No, be there tomorrow’.” Despite low interest rates, the impact of Basel III is likely to drive up the cost of borrowing significantly. A glimmer of hope surrounds the prospect of new debt sources, from CMBS to insurers and mezzanine providers, but a lack of senior lending makes it tough for the latter to deploy capital.

Some even predict the arrival of Chinese banks, encouraged by Bank of China’s $800m refinancing of a Manhattan office tower in 2010. CMBS is expected to return at the highest quality in 2011, although it will undoubtedly be a slow process. The consen-sus is that even if new players do emerge, they will take a long while to do so and will only partially relieve the debt congestion.