Working it out

NPL work-out strategies have proved lucrative for investors, writes Lauren Parr.

Non-performing real estate debt once worth billions of euros has changed hands since banks’ deleveraging began in earnest in 2011. The US private equity giants that have dominated portfolio acquisitions are understood to have successfully worked out many of the earliest books to generate stellar returns.

“Buyers all target 20 percent returns, and the NPLs outperform their expectations,” says one advisor familiar with selling assets originally acquired through European loan sales. “In a loan book of several hundred loans, they will invariably have lost money on some and so the blended returns will be between 20-30 percent, although investors will never confirm this.”

Project Isobel, the first major property loan portfolio to be packaged up by a UK bank back in 2011 is the prime example of a successful work-out. Royal Bank of Scotland formed a joint venture with Blackstone for the £1.36 billion portfolio backed by UK property. Subsequent loan and asset sales during the market recovery years followed. Late last year, Davidson Kempner bought the last remaining element – a portfolio of UK car parks for £500 million.

Although visibility on loan portfolios once acquired is very limited, market watchers say that loan books bought between 2011 and 2013 have been generally fully resolved, with recovery times typically in line with buyers’ underwriting.

“If a fund is able to exit an investment in a relatively short timeframe of a couple of years, and the buyer of the asset is an institution, you can be fairly certain that relevant the US PE house made money,” says Jason Winfield, head of UK investment at Cushman & Wakefield, who has advised on asset sales.

NPL portfolios sold up to around 2014 were “dirt cheap”, according to one loan sale advisor. “But the market was pretty rough and there was no clear view of liquidity. Purchasing a big portfolio between 2012 and 2013 was quite bold; liquidity kicked in only afterwards. This is the stuff that probably made the most money.”

Early movers like Kennedy Wilson bet on macroeconomic fundamentals improving. The investor was one of the first to enter the Irish market. It teamed up with US hedge fund Värde Partners to buy the €306 million Castle Market Holdings portfolio in 2013. It bought the CMBS debt attached to the 16 underlying assets at an 11 percent premium to the portfolio’s €275.17 million valuation.

“Most of the properties were good quality, stabilised assets – only two or three needed work. They made a bet on yield compression and got it right,” says Paul Severs, a partner at law firm Paul Hastings, who was familiar with the deal.

Discounted pay-offs

While some NPL buyers have executed loan-to-own strategies to seize control of properties, much business has been worked out through discounted pay-off credit deals.

Dublin and London-based Earlsfort Capital Partners was set up in 2014 with US private equity backing to provide high-leverage loans to finance DPO deals on Irish and UK property loans. Managing director Fergal Feeney estimates that around half of borrowers whose debt sells to an NPL buyer successfully negotiate a buy-back of their assets, usually within three to six months of a loan sale.

“There have been huge volumes of loan trades in Ireland over the past four years, which has created good opportunities for alternative lenders,” Feeney says.

For many NPL buyers, quick DPO deals are the optimum strategy, making loan portfolio purchases a credit play which can generate significant returns. However, as the NPL market has matured and competition for loan books has increased, there is less discount to pass on to borrowers.

“The first portfolios were traded at bigger discounts to market value. Now they’re trading at a price closer to market value so there’s less room to provide a discount,” says Alex Rowbottom, managing director of debt strategies at CR Investment Management. “In the UK, borrowers are primarily being forced to refinance; most people can find a solution.”

Investors with a loan-to-own strategy buy NPLs wholesale and resell bits of the portfolios to third parties. Often, funds will identify obvious buyers to flip loans out to before a portfolio sale is complete. For example, a chunk of the £2.25 billion Project Churchill UK loan book Lone Star bought from Aviva was sold to Tristan Capital in December 2015, just three months after the original trade. Tristan bought loans secured against 17 properties in a deal worth around £150 million.

Granular assets have come out in a couple of situations from some of the first NAMA sales, though secondary loan sales are not widespread. “Many PE funds’ servicing platforms are best suited to large, complex loans versus small assets,” says Gifford West, managing director of debt auction platform DebtX.

Asset sales have been done through auctioning individual properties. “Stamp duty and buy-to-let tax has changed so people that would have bought houses are buying industrial units and single shops,” Winfield says.

Larger lot sizes have been packaged up for sale to institutions. In Germany, Oaktree is understood to have sold a circa €150 million portfolio of German retail assets that it bought as part of Project Adelaide from Nationwide in 2014.

Real estate NPL transactions have the potential to create controversy. Distressed debt coming into the ownership of a US private equity firm typically means that the property owner will either be compelled to raise finance to bring to a close stalemate debt situations, or will face enforcement proceedings with their property ultimately seized. The Irish press, for instance, has highlighted aggressive tactics by some NPL buyers when dealing with borrowers.

CR’s Rowbottom argues that European work-outs have predominantly resulted in consensual agreements which draw to a close long-running situations: “In general it’s a good thing because it cleans the system; if banks’ balance sheets are constrained by huge amounts of NPLs it’s not good for the broader market. In private hands, there is impetus to get things resolved.”

Spanish work-outs reveal mixed fortunes

A combination of vigorous management on the part of the servicer and a significant recovery in the Spanish real estate market over the past couple of years means the work-out of Spain’s largest non-performing commercial real estate portfolio trade is almost complete, according to market sources.

Commerzbank sold the €4.4 billion Project Octopus, including loans backed by hotels and shopping centres, to Lone Star and JPMorgan in June 2014. Lone Star bought the €1.4billion non-performing loan pool; JPMorgan the performing debt. One of the last properties to be marketed from the portfolio is currently being sold by CBRE.

While Octopus comprised high quality commercial real estate, investors that bought portfolios of land or residential with more contentious work-outs are struggling to come up with solutions that meet returns targets. “Spain has a complex legal system; it’s a more difficult environment in which to enforce. Certain parties may have been too quick to invest,” says one work-out specialist.

There was a rush of capital into Spain in 2013 through to 2015 where a lot of investors bought not only loan portfolios, but servicing platforms from some of the big banks.

“People who bought 10-year servicing contracts from Spanish banks anticipated they would get a lot of internal data that would help them underwrite and acquire other portfolios. But it has not transpired as they thought. There is currently a shake-up of the servicing market in Spain,” says Rowbottom.