Flocking to EuropeErnst & Young 2013non-performingloan report
ii Flocking to Europe Ernst & Young 2013 real estate non-performing loan report
iiiFlocking to Europe Ernst & Young 2013 real estate non-performing loan reportWelcome to our fifth NPL investor surveyOnly a year or so ago, global investors in distressed loans were primarily focused on theUS. Today, as our latest survey attests, investors increasingly are seeking investments inEurope’s emerging market for distressed debt. They also continue to look for investmentopportunities in the US. Although the US distressed loan market has slowed, the marketstill offers ample investment opportunities, according to investors who participated in ourcurrent survey. In fact, almost 70% expect the US market to remain active over the next 12to 36 months.Yet, conflicting signals abound in today’s US non-performing loan (NPL) market.On the plus side, bank earnings have soared, while loan loss provisions, loan charge-offs,failed bank closures and the number of problem banks have all declined. The FederalDeposit Insurance Corporation’s (FDIC) fourth quarter banking data paints a picture ofa stable and steadily improving banking industry. In commercial real estate, the headygrowth enjoyed by certain property types and locations has allowed certain borrowersto keep their loans current, continue to invest in their properties and take advantage ofrefinance opportunities.However, issues remain. Property values have increased mainly in key US markets forhigh quality assets. Elsewhere in the US, values remain depressed and borrowers continueto struggle. Real Capital Analytics reports that US$164 billion in commercial real estatemortgages remain distressed. Furthermore, tens of billions in looming maturities are aconstant threat to both borrowers and lenders because depressed property values limitborrowers’ ability to refinance, increasing the risk of default at maturity.As for banks, commercial real estate (CRE) loans constitute only 7% of the total assetsof big banks. However, for banks with US$10 billion or less of assets, CRE loans accountfor a disproportionate 26% of total assets. These banks will likely focus on reducing thepercentage of CRE loans on their balance sheets through sales and other measures, whichcould provide opportunities for investors to acquire loan portfolios or individual loans.Yet, big global investors with huge pools of capital are starting to look outside the US. It’sno secret that the US nonperforming loan market has not lived up to the expectation ofthese investors. In the meantime, European banks have increasingly begun to reduce theirexposure to NPLs via portfolio sales. Consequently, global NPL investors are turning theirattention to Europe, and for good reason. An estimated €1 trillion of NPLs are sitting onthe balance sheets of the region’s banks, far surpassing the magnitude of distress in the US.For this year’s report, we have included European-based investors in our survey. Theirconsensus is that the markets with the most opportunity are the UK, Ireland, Germanyand Spain. And investors are taking the long view. As one notes, “we believe Europe is inthe early stages of resolving what appears to us as a very large problem with respect todistressed loans.” For the first time since the global financial crisis and property marketdownturn, investors now have opportunities on both sides of the Atlantic.As always, we would like to thankthe investors who participatedin our survey. We very muchappreciate your perspectives onthe changing market.Christopher SeyfarthPartner, Ernst & Young LLPHoward RothGlobal Real Estate Leader
Flocking to Europe Ernst & Young 2013 real estate non-performing loan reportAlthough the US NPL1market remained active in 2012, theremay have been less investment activity simply because therewere fewer investment opportunities. The FDIC was not as activein selling loans. The amount of net NPLs in banks’ portfolios hasbeen declining (see “Distressed loans,” page 6), which suggeststhat banks have fewer NPLs to sell, although a substantialamount remains on their books. Some NPL transactions werenot completed because investors and banks could not agree onprice, and some banks simply stayed out of the market.Nevertheless, our survey respondents said they expect theUS NPL market to remain active, although for a shorter timeframe than they anticipated a year ago. The US economycontinues its slow but steady growth, commercial propertymarkets are improving and property values are rising. Thesedevelopments should help bridge the pricing gap between sellersand investors and make conditions more favorable for NPL sales.Furthermore, banks and servicers of commercial mortgage-backed securities (CMBS) face a huge increase in loans maturingover the next few years — and the risk that this might result inan increase in their NPLs. That risk might motivate banks andspecial servicers2to accelerate sales of their existing NPLs aswell as subperforming loans.Meanwhile, Europe is emerging as an NPL market in its ownright, with an estimated €1 trillion of NPLs on the balance sheetsof the region’s banks. In addition to local investors, the marketis drawing more investment from international investors, withNPLs collateralized by commercial properties in Germany, theUK, Ireland and Spain currently attracting the most interest.Sales of NPLs could increase in 2013 as sellers take advantageof the demand and investors grow more confident in the stabilityof Europe’s economy and the euro and are therefore more ableto meet sellers’ price expectations. Sales activity is in its veryearly stages, however, and banks could be selling NPLs forsome time to come.In this year’s report, we look at the NPL investment marketsin the United States and Europe and how our survey respondentsview investment opportunities in the two markets. For the firsttime, our survey includes European investors, who constitutednearly a third of respondents. The rest were US investors.(A summary of the survey results begins on page 19.)
2Flocking to Europe Ernst & Young 2013 real estate non-performing loan reportBanksBy many measures, FDIC data shows that banks have returnedto profitability and their balance sheets are strengthening:2012 earnings increase 19.3% to US$141.3 billion,the second-highest amount everThe banks’ 2012 earnings were about US$4 billion less thanthe record US$145.2 billion in 2006. The largest contributionto the increase in 2012 earnings came from reduced provisionsfor loan losses, which fell by US$4.9 billion (or nearly 25%)from 2011.Fourth quarter 2012• Profits increase more than a third over Q4 2011Insured banks and savings institutions earned US$34.7billion in Q4 2012, a 36.9% increase from Q4 2011 andthe highest fourth-quarter total since 2006. Well over halfof all institutions (60%) reported higher earnings than ayear earlier, and only 14% reported losses, down from 20%a year earlier. Reduced expenses for loan losses and risingnoninterest income accounted for most of the year-over-yearimprovement in earnings.3United States• Loan loss reserves decline 25%Banks’ loan loss reserves were US$15.1 billion in Q4 2012, ornearly 25% less than the US$20.1 billion in Q4 2011, markingthe 13th consecutive quarter that the industry’s reserveshave declined.• Net loan charge-offs declineBanks’ net loan charge-offs (NCOs) also declined in Q4 2012,to US$18.6 billion, or 27%, from US$25.6 billion a yearearlier, making it the 10th consecutive quarter NCOs havedeclined. All major loan categories improved from the prioryear. In real estate construction and development, NCOsdeclined by US$1.3 billion, or nearly 63%.• Bank failures fallThe number of bank failures fell to 51 in 2012 from 92 in2011.4The number of failures in 2012 was about a third ofthe 157 failures in 2010, which was a nearly 20-year high.• Number of problem banks declines sharplyThe number of banks on the FDIC’s “problem list” declinedin Q4 2012 to 651 from 813 in Q4 2011. This marked theseventh consecutive quarter that the number of “problem”banks has fallen, and the first time in three years that fewerthan 700 banks were on the list. Total assets of “problem”institutions declined to US$233 billion from US$319 billiona year earlier.Page 1Bank earnings 1Q07- 4Q12Quarterly profits continue to improve-$40-$30-$20-$10$0$10$20$30$401Q072Q073Q074Q071Q082Q083Q084Q081Q092Q093Q094Q091Q102Q103Q104Q101Q112Q113Q114Q111Q122Q123Q124Q12US$billionSource: FDICNinth consecutive quarter that industry earnings have irSource: FDIC; as of 12/31/20124Q2012 net income was the highest fourth quarter total since 2006Bank earnings 1Q07–4Q12Quarterly profits continue to improve
3 Flocking to Europe Ernst & Young 2013 real estate non-performing loan reportPage 2Loan loss provisions 1Q07- 4Q12Expenses for bad loans fall again$0$10$20$30$40$50$60$70$80US$billion4Q2012 loan loss provisions declined year-over-year for the13th consecutive quarterSource: FDIC; as of 12/31/2012Page 3Net loan charge-offs 1Q07- 4Q12Loan losses improve across most loan categories$0$10$20$30$40$50$601Q072Q073Q074Q071Q082Q083Q084Q081Q092Q093Q094Q091Q102Q103Q104Q101Q112Q113Q114Q111Q122Q123Q124Q12US$billionQuarterly net loan charge-offs drop to lowest amount since 1Q08Source: FDIC; as of 12/31/2012Loan loss provisions 1Q07–4Q12Expenses for bad loans fall againNet loan charge-offs 1Q07–4Q12Loan losses improve across most loan categories
4Flocking to Europe Ernst & Young 2013 real estate non-performing loan reportPage 4$0$50$100$150$200$250$300$350$4000501001502002503003504004505005501988198919901991199219931994199519961997199819992000200120022003200420052006200720082009201020112012Assetsoffailedbanks–US$billionFailedbankcountFailed banksTotal assets and failed bank countSource: FDIC; as of 12/31/2012The pace of bank failures has declined over the past two years but remainsat recent historically elevated levelsAssets of failed banksPage 5“Problem” banks 1Q07- 4Q12Numbers of “problem” banks and bank failures decline$0$50$100$150$200$250$300$350$400$450$500010020030040050060070080090010001Q072Q073Q074Q071Q082Q083Q084Q081Q092Q093Q094Q091Q102Q103Q104Q101Q112Q113Q114Q111Q122Q123Q124Q12Assetsofproblembanks–US$billion#ofproblembanksSource: FDIC; as of 12/31/2012Number of institutions on the FDIC’s problem list declinedfor seventh consecutive quarterAssets of problem banksFailed banksTotal assets and failed bank count“Problem” banks 1Q07–4Q12Numbers of “problem” banks and bank failures decline
5 Flocking to Europe Ernst & Young 2013 real estate non-performing loan reportRisksUS banks turned in a very strong performance in the fourthquarter of 2012 and for the entire year, continuing a trendof positive earnings that began nearly three years ago.However, their problems with non-performing loans are notbehind them — yet.• Non-current loan balances remain highDespite a reduction in non-current loans to US$276.8 billionfrom US$292.8 billion at the end of the fourth quarter, suchloans are still about 2.5 times higher than when the recessionstarted in December 2007.• Nearly half of all banks added to loan loss reservesWhile banks’ total loan loss reserves declined by nearly 25%or US$4.9 billion in Q4 2012, to US$15.1 billion, much of thereduction was concentrated in the larger banks. Nearly half ofall institutions added to their reserves in the quarter.• Maturing loans remain an issueMaturities continue to be problematic for banks and specialservicers. (See “Maturing CMBS loans,” page 8.) The problemis that many of the banks’ outstanding CRE loans do notmeet their current underwriting standards. For banks, thechallenge is how to best deal with this risk exposure as theseloans mature.• Number of problem banks declines but is still relatively highAlthough 651 problem banks were on the FDIC’s watch listat the end of 2012, down sharply from 813 a year earlier,that number was still much higher than in 2006, before thefinancial crisis, when there were only 50 problem banks.• Loan-to-deposit ratios declineThe banking industry’s loan-to-deposits ratio declined in2012 to 72% from 95% in 2007. Deposits reached a recordUS$10.6 trillion at year-end 2012. Since 2008, however,loans outstanding at US banks and thrifts have declined 5.3%to US$7.58 trillion (as of early 2013).5CRE loan exposureIf you compare the amount of CRE loans held by the top 100US banks with the remaining US banks, you get a relativelybalanced picture. As of September 2012, US banks held US$1.5trillion of CRE loans, with the top 100 banks holding US$766billion, or 51%, and the remaining banks 49%, or US$734billion. Based on both dollar amount and percentages, the twocategories of banks were fairly even.Compare the CRE loans of these two categories of banks againsttheir total assets, however, and you get a very different picture.Of the US$11.3 trillion of total assets of the top 100 banks,CRE loans accounted for just 7% of the total. By contrast, CREloans made up 25% of the nearly US$3 trillion of assets of theremaining banks.Table #1: US banks: CRE loan exposureBanks Total assets CRE loans% ofbalancesheet7,190 total banks US$14.5 trillion US$1.5 trillion 10.4%Top 100 banks US$11.5 trillion US$755 billion 6.6%Remaining banks US$3.0 trillion US$760 billion 25.3%Source: FDIC as of 12/31/12Composition of CRE loans:top 100 vs. remaining banksOutside the top 100 banks, the remaining 7,000 or so USbanks are mainly regional and community banks. They holdconstruction loans, acquisition and development loans, andcommercial property loans on thousands of small officebuildings, retail centers, apartments and condominiums, andother commercial real estate nationwide. Individually, these aresmall loans, but, in aggregate, they constitute a significant partof the CRE loan market in the US.By contrast, the largest banks tend to hold loans on large, high-profile office towers, regional shopping centers and high-riseapartments in leading markets in the US and globally. Whilemany banks, from global institutions to small community banks,experienced an increase in distressed CRE loans, regional andsmaller banks have been especially affected because of theirgreater CRE exposure in relation to their asset size.
6Flocking to Europe Ernst & Young 2013 real estate non-performing loan reportDistressed loansIn December 2007, at the onset of the US recession andfinancial crisis, distressed loans on the balance sheets of USbanks totaled just US$9.7 billion. Cumulative commercial realestate NPLs6held by banks, CMBS investors, and others haveincreased ever since, reaching US$354 billion in December2011 and US$394 billion in December 2012 (the latest monthfor which information is available).Because of banks’ steady progress in resolving NPLs, their netdistressed loans peaked in February 2011 at US$188 billion.Net NPLs have declined since then; however, as of December2012, lenders still held US$164 billion of distressed loans.72013 bank outlookAfter rapid growth in 2012, US bank deposits fell sharplyat the 25 largest US lenders in early January. Some marketanalysts said a key reason might have been the end of theFDIC’s Transaction Account Guarantee (TAG) Program, whichguaranteed non-interest-bearing accounts above the FDIC’sgeneral US$250,000 limit.8Whether this is the start of a long-term decline in deposits remains to be seen.In December 2012, the banks’ loan activity unexpectedlyjumped as corporate borrowers hurried to close loantransactions before tax law changes took effect in 2013 as aresult of the fiscal cliff.9In early 2013, bank lending to businesses surged as large banksas well as small institutions sought to put their deposit moneyto work. Some banks reportedly are easing credit standardsin an effort to beat competitors in originating loans, but thenew business has come at a cost: a decline in loan yields and anarrowing of loan margins.10ConsolidationConsolidation in the banking industry could be another driverof NPL sales. Invictus Consulting Group LLC said in a study thatmore than half of the 7,000-plus US banks should undertakemerger and acquisition activity to preserve shareholder value.Banks across the country are facing increased regulatory capitalrequirements, declining net interest margins and increasedcompetition, leaving many banks with no prospect of organicgrowth.11If consolidation accelerates, more NPL portfolios willlikely come on the market as banks clean up their balance sheetsin preparation for or subsequent to mergers.Flocking to Europe | 2013 distressed real estate investor surveyPage 25Additions to distress$(10)$(5)$-$5$10$15$20$0$50$100$150$200$250$300$350$40007 08 09 10 11 12Netchangeindistress(US$b)Cumulativedistress(US$b)Net Change in Distress Total Cumulative Distress Net Cumulative DistressNet change in distress Total cumulative distress Net cumulative distressTotal distressSource: Real Captial Analytics
7 Flocking to Europe Ernst & Young 2013 real estate non-performing loan reportCMBS market reboundsThe delinquency rate of loans that underlie commercialmortgage-backed securities declined to an 11-month lowin January 2013, according to researcher Trepp LLC.15The delinquency rate fell to 9.57% in January from 9.7% inQ4 2012. January’s rate was the lowest since February 2012,when it was 9.38%.In 2012, CMBS issuance reached nearly US$48.2 billion.That was far below the peak of the market in 2007, when USissuance exceeded US$228 billion. But after almost coming to ahalt in 2008, the market has made a strong comeback. Investordemand for CMBS bonds has been increasing on the strengthof the recovery in the institutional quality commercial propertymarkets.16Indeed, based on CMBS issuances through February2013, underwriters are on pace to issue US$100 billion innew bonds for 2013. Based on only two months’ volume, thatnumber may not be achieved; however, it’s a comforting signalfor borrowers that the CMBS market is on its way back.Some property owners who once were shut out of creditmarkets recently have found that they can obtain commercialmortgage financing at relatively low interest rates andincreasingly lenient terms via the CMBS market.17How longconditions will remain this favorable for borrowers is uncertain.But, if interest rates should rise, financing costs will increase,likely limiting the ability of property owners to borrow.2013 commercial property outlookMarket analysts say the US commercial property market shouldcontinue to recover in 2013, based on the slow but sustainedgrowth of the US economy and improvement in propertyfundamentals. However, to date, that improvement has beenconcentrated in US gateway cities, such as New York, LosAngeles, Chicago and San Francisco. Outside these centersof commerce, commercial property values have risen onlymodestly at best, and some tertiary property markets continueto languish.US economy: 2.4% growth consensus forecastfor 2013The consensus forecast of economists surveyed by The WallStreet Journal in early February was that the US economywill grow at a steady but unspectacular 2.4% rate this year. In2012, the economy grew at a 1.5% rate, the US CommerceDepartment reported.12Unemployment is forecast to drop to7.4% from 7.8% in 2012.Vacancy rate expected to declineIn its November 2012 quarterly commercial real estate forecast,the National Association of Realtors said commercial propertyvacancy rates are expected to decline in 2013.13The officesector should continue to have the highest vacancy rate andmultifamily the lowest.Table #2: Commercial real estate vacancy forecastSector Q4 2012 Q4 2013Office 16.7% 15.7%Industrial 10.1% 9.5%Retail 10.8% 10.6%Multifamily 4.0% 3.9%Source: National Association of RealtorsIn another positive sign, Green Street Advisors reported thatinstitutional quality commercial property values moved steadilyhigher in 2012. As of early January, some property sectors inkey national markets were close to their 2007 highs.14
8Flocking to Europe Ernst & Young 2013 real estate non-performing loan reportMaturing CMBS loansWhile CMBS new loan originations are improving, two issuescontinue to loom over the market. One is the persistence ofdelinquencies on CMBS legacy loans. The other is a sharpincrease in maturing CMBS loans that will begin in 2015. Untilthen, the CMBS loan market will remain relatively stable. Morethan US$50 billion in CMBS loans will mature this year andabout the same amount in 2014. In 2015, however, maturingloans will jump to US$97 billion and, in 2016 and 2017, to morethan US$130 billion. In 2018, they will drop to US$7 billion.18The spike in maturing loans over the next few years is significantbecause some borrowers will not be able to pay off or refinancetheir loans and will be at risk of default. Some of these loanswere written in 2007 at the height of a commercial propertyboom, and borrowers were able to finance 80% or more ofproperty values. Today, lenders are financing or refinancingmortgages at lower percentages of property values, thusrequiring property owners and developers to invest more equityin their properties. By one estimate, the equity shortfall willequal about US$100 billion annually for the next three to fouryears.19That is equity some borrowers may not have, and unlessthey are able to negotiate loan extensions or refinancings withlenders, they could be at risk of defaulting — and lenders couldbe at risk of adding more NPLs to their portfolios.2013 NPL sales outlookBanks began stepping up their NPL sales in 2009, and salesactivity has continued to increase. Information about salesfigures is hard to come by, but it’s estimated that banks’ salesof non-performing CRE loans totaled at least US$15 billion in2012, down from approximately US$26 billion in 2011.While many banks and CMBS special servicers have been activesellers of NPLs, some have foregone sales. Part of the reasonmay be that they have been waiting for the US economy torecover more fully and property markets to rebound. Also,they may not have been willing to sell loans at the discountsnecessary to attract investors. Even if they were to sell, banksdo not want to incur losses that would reduce their profits anderode their capital, and special servicers do not want to reducedistributions to CMBS investors.More reason to sell in 2013?Those banks and CMBS special servicers that so far haverefrained from selling NPLs may have more reason to do so in2013. If the US economy continues its slow-but-steady growthand the US unemployment rate continues to decline, theremight be a modest increase in demand for space in commercialproperties this year. Commercial property values are recovering,and vacancy rates are declining, although vacancies remain athigh levels except for multifamily properties. “U.S. banks holdinglarge levels of non-performing assets (NPAs) on their balancesheets are likely to pursue more bulk sales of distressed loansthis year and next,” according to Fitch Ratings.20It said that ifmarket liquidity and asset pricing continue to improve in 2013,many smaller institutions with large residual NPA balances will bebetter positioned to use bulk sales to strengthen balance sheets.
Donald Sheets is a senior principal in the New York officeof Square Mile Capital Management (SMCM), a real estateprivate equity fund with US$1.9 billion in assets undermanagement (AUM).At SMCM, Sheets structures and negotiates nontraditionalcommercial real estate investment opportunities, includingdistressed debt, discounted performing commercial mortgages,preferred equity, mezzanine financing and real estate enterpriseliquidations. He has more than 13 years of property acquisition,turnaround, asset management and restructuring experienceacross a variety of capital structures, asset typesand geographies.Sheets is an adjunct assistant professor of real estatedevelopment in Columbia University’s Graduate School ofArchitecture, Planning and Preservation.Could you provide an overview of SMCM? We’re anopportunity fund focused on special situations investing. Asa result, we’re active in acquiring and resolving performing,subperforming and non-performing commercial mortgage loans,with a focus on the US market. We’re also pioneering on thefinancing front. We’ve created unique structures, for example,with respect to the securitization of pools of performing andnon-performing debt. In 2012, we brought to market one ofthe first liquidating trusts that had been done in years, and wecompleted another one at year-end.On the acquisition side, is SMCM primarily focused oncommercial mortgage loans — performing, subperforming,non-performing? Yes, but we have a mandate for otherbusiness as well. We’re active in providing capital for consensualrecapitalizations alongside capable but over-levered borrowersto effectuate DPOs (discounted payoffs) with existing lenders. Inthese situations, we effectively are recapitalizing the equity siderather than the debt side. We also are actively originating newmezzanine financing via a separate account that we manage onbehalf of a large insurance company’s real estate subsidiary.What returns are you looking for? About three-fourths ofthe loans we buy are performing and subperforming, and theremainder are NPLs. Our return criteria are different than thoseof a buyer that invests mostly in NPLs or those investors with apredicated “loan to own” strategy. We generally look for returnsin the low to mid teens on unlevered transactions, and leveredreturns in the mid to upper teens.Do you have a sense of what the volume of US NPL sales wasin 2012? I would say around US$40 billion, which would includeperforming and subperforming loans as well. In 2011, theremay have been around US$50 billion in sales. But it’s a difficultnumber to pinpoint.What’s the outlook for US NPL sales in 2013? From our viewof the debt pipeline, 2012 had less volume than 2011. But2011 sales were magnified by the Anglo Irish, Bank of Irelandand Allied Irish Bank sales of their commercial real estate loanportfolios. If you strip Irish portfolio sales away, then 2012 wasabout as busy as 2011. As for 2013, I look for it to be about asactive as 2012.Who will be selling this year? The caliber of sellers istransitioning a bit. The FDIC clearly is not as active as it was. Itmay do a structured sale or two specifically aimed at smallerinvestors or it will securitize small balance claims. The agencycompleted a couple of securitizations in 2011 and 2012. Iwouldn’t be surprised if it uses that mechanism going forwardversus the structured sale format. I don’t see them as that activeof a contributor in 2013, primarily because the number of failingbanks is decelerating.What about special servicers? Special servicers for NPLscertainly will remain active, and that activity should increasein 2013. Unfortunately, those sales of claims probably will bethrough the online auction process, which most institutionalinvestors do not participate in.So special servicers will put assets up for auction on a one-off basis? Yes, small balances — anything between US$1 millionand US$10 million — tend to be placed into an online auction site.It’s distorting in terms of knowing what’s actually trading and atwhat price levels.Interview with Donald Sheets, Square Mile Capital Management9 Flocking to Europe Ernst & Young 2013 real estate non-performing loan report
And there will also be negotiated sales by banks in 2013?Yes, there will be negotiated transactions through traditionalchannels. Market participants also are talking about loss-shareagreements maturing.21Beginning probably in the second halfof 2013, and continuing through 2016, buyers of failed banksacquired from the FDIC under loss-share agreements will resolveor liquidate in bulk non-performing assets. Any assets that thebanks aren’t able to resolve before the end of their five-yearwindow for loss recovery will probably go back on the market.That five-year period generally started between 2008 and 2011.This suggests that there could be an increase this year and overthe next few years in sales driven by these loss-share agreements.Who else will be selling NPLs in 2013? Other sellers willinclude well-capitalized money center banks that have extendedor modified loans on at least one or more occasions. Theywill look for liquidity by selling loans, which generally will besubperforming loans rather than non-performing. These loansmay be a bit over-levered and likely have been previouslyrestructured. These banks have sufficiently marked down mostof their loan books and now have the earnings to absorb lossesfrom selling them. In addition, some European banks that stillhold portfolios of US commercial mortgages might continue tobring these portfolios to market in 2013.How are buyers financing deals? Leverage terms havecontinued to evolve. I would say that there are five or sixcredible financing sources in the market. In addition, as of 2012,there is also the public market, in the form of liquidating trusts.In leveraged transactions, the advance rate has increased andthe coupon has decreased. That makes the cost of capital moreefficient to bridge the bid/ask spread in the marketplace.There have been just a few big transactions by US banksand foreign banks, but we really haven’t seen many sizabletransactions. Is that what you’re seeing? We expectcontinued portfolio sales in 2013. But I also believe that we’llsee one-off sales of large single loans backed by multipleassets. Examples will include a credit facility secured by sevenor eight assets, or a single loan to a company that is secured bythe company’s assets, which might include real estate. Someportfolios of participations also could come to market this year.Sellers will include banks that are in various credits but donot have full control rights and are looking for liquidity or arewinding down legacy loan books.How do you identify opportunities and set up your pipeline?It’s a mix. In this market, some sellers have to use a transparentprocess, so we see product coming through the advisorychannel. But that doesn’t necessarily mean a lot of qualifiedbidders show up. Only two or three credible bids may be madethat can close. So there are auctions — either broad auctions orlimited auctions. Then there are the bespoke transactions thatusually are one-off. Over the years, I’ve built relationships withseveral banks, and if they have something to trade quietly andswiftly, usually in the form of a one-off credit or two, we canusually do a direct negotiation with the seller.Any preferences on loan type and deal size? We’re agnostic ongeography, asset class and loan performance status. We typicallyinvest at least US$15 million in a single transaction, and we haveacquired portfolios in excess of US$600 million in outstandingprincipal balance.Do you see opportunities in Europe? We presently areexploring opportunities in Europe, which is in the early stages ofNPL portfolio sales. To use a baseball analogy, the fans are justtaking their seats. Once there’s a mandate from the EuropeanCentral Bank for banks to start winding down their NPLportfolios, there will be more product coming out of banks, butI don’t know what they will look like since we are just beginningto investigate the marketplace. Which loans will come out ofbanks first? Better quality? Worse quality? Small balance? Itremains fluid.How does that baseball analogy apply to the USNPL market? I would say the US NPL market is in the fourthor fifth inning in terms of sales activity. Some people aremoving away from buying mortgages and instead are migratingtoward acquiring properties directly. Therefore, the market forsecondary commercial mortgage debt is a little less crowdedtoday, which makes us happy.Flocking to Europe Ernst & Young 2013 real estate non-performing loan report 10
11 Flocking to Europe Ernst & Young 2013 real estate non-performing loan reportEurope’s market for non-performing loans is growing. Estimatesvary, but the market could be as big as €1 trillion to €1.5 trillion.“By far, Europe represents the biggest opportunity worldwide,”said Lee Millstein, Head of European and Asian Distressed andReal Estate Investments at Cerberus Capital Management. (Aninterview with Millstein appears on page 15.)The opportunities in Europe have commanded the attentionof global investors. “Europe will attract more investment frominvestors worldwide, and the pipeline will grow over the next fewyears,” said David Abrams. He is Senior Portfolio Manager ofNon-performing Loans at Apollo Management International andManaging Partner and Co-Founder of Apollo European PrincipalFinance Fund. (An interview with Abrams appears on page 23.)Investor interest isn’t limited to non-performing real estateloans. European real estate generally is attracting moreinvestment, particularly from US investors.22In December2012, the German Government agreed to sell TLG Immobilien,a company that owns stores, offices, warehouses and hotels inthe country’s eastern states, to Lone Star Funds for €1.1 billion,including debt.23Compared with a year ago, investors today see the Eurozone’sfuture as more secure. Central Bank policies have reduced theimmediate risk of a Eurozone breakup, while progress has beenmade toward a banking union that would put the euro on astronger long-term footing.24Sale and refinancing targetsMorgan Stanley estimates that Europe’s banks need to sellor refinance €700 billion of NPLs to meet regulatory capitalrequirements, deleverage their balance sheets and achieveother goals. As of January 2013, banks had sold or refinancedNPLs equal to 20% to 25% of that target.25Since the financial crisis, about half of the reductions to banks’loan books has come from borrowers repaying debts, accordingto Morgan Stanley. Roughly 20% has come from debt sales, andanother 25% has come from writing down debt. The balance hascome from asset repossessions, primarily in Spain.Until now, the leading international buyers of Europe’s distressedloans have been US-based private equity firms. Such is thedemand for NPLs, however, that other investors have enteredthe market, including smaller private equity firms, sovereignwealth funds, wealthy individuals, family offices and US realestate investment trusts (REITs). In some cases, these investorshave offered higher prices than the big firms. Some banks arestarting to sell individual assets or small portfolios to theseinvestors while continuing to do large portfolio transactions withthe biggest investors.26EuropeMore investor interestAt an Ernst & Young real estate workshop held in January 2013in London, we surveyed workshop participants on the outlookfor real estate NPL investment in Europe this year.27Aboutthree-fourths of those responding to the workshop survey saidthey expect deal flow to increase in 2013. As for their ownplans, about 85% said they are in a “buying mode.” AmongEuropean countries, the UK will be the most active market forinvestment, according to two-thirds of respondents: about 22%said Spain and 11% Ireland.Another sign of interest in Europe’s NPL market comes fromthe survey of real estate NPL investors for this report. (Nearlya third of the survey respondents are based in Europe and therest in the US.) Of all of the respondents, a third said Europewill be their primary focus for NPLs over the next 12 months.The respondents focused on Europe are primarily interestedin investment opportunities in Germany, the United Kingdom,Ireland and Spain. (See responses to Question 5 of the surveyon page 25 of this report.) More than half of the respondentssaid the European market will remain active for the next 36to 48 months.European banks: more exposure tocommercial property lendingNPLs secured by commercial real estate are a primary target ofinvestors, because European banks are prominent commercialproperty lenders, among other reasons. In Europe, aboutthree-fourths of outstanding commercial mortgage debt isheld by banks versus CMBS or insurance companies or otherinstitutions. By comparison, in the US, banks account for about55% of commercial mortgage debt.28Furthermore, Europe’sCMBS market is relatively small compared with the US marketbecause European banks generally keep loans on their balancesheets rather than securitizing them, so European banks havemore exposure to the risks of commercial real estate lending —including the risk of some performing property loans becomingnon-performing. Moody’s said in a January 2013 report thatmany European banks, particularly those in Spain, Italy, Irelandand the UK, require material amounts of additional provisionsto fully clean up their balance sheets.29It did not say how muchmoney would be needed.
12Flocking to Europe Ernst & Young 2013 real estate non-performing loan reportTable #3: European banking snapshot302012 2013* 2014*Total assets (€bn) 33,631 33,200 33,928Total loans (€bn) 12,264 12,132 12,487Business and corporateloans (€bn)4,619 4,628 4,821Consumer credit (€bn) 604 597 606Residential mortgage loans (€bn) 3,791 3,767 3,827NPLs as % of total gross loans 6.8 7.6 5.6Deposits (% year) 0.9 3.2 4.1Loans/deposits(% increase from prior year)111 106 105Total operating income (€bn) 632 651 706*Source: Ernst & Young Eurozone ForecastNPLs expected to peak in 2013In the Eurozone, total NPLs (including real estate) as apercentage of banks’ total loans increased from 5.6% in2011 to 6.8% in 2012. This year, the Eurozone’s economy isexpected to contract slightly, and, based on Oxford Economicsresearch, NPLs will reach a euro-era high of €932 billion,amounting to 7.6% of total loans of €12.2 trillion, according toan Ernst & Young report.31As economic conditions improve in2014, NPLs are expected to drop to 5.6% of €12.5 trillion ofoutstanding loans, or the same percentage as in 2011. However,the Eurozone’s growth is expected to be modest, averagingabout 1.3% annually for the rest of this decade.32To sell or not to sellThe expected increase in NPLs in 2013, as well as regulatoryrequirements and banks’ increased focus on profitability, couldmotivate banks to unload more of their bad loans. In addition,banks will continue to focus on strengthening their balancesheets and cutting costs in 2013,33and they will try to sellNPLs as part of the process of deleveraging and improvingtheir financial position. Finally, as we noted in a 2011 report onEurope’s NPL market, some banks are changing to a stronger,more sustainable and more competitive business model, onethat balances the need for profit against an appropriate level ofrisk.34This gives them another reason to sell NPLs.Alternatives to sellingAs an alternative to selling NPLs, banks could restructuresome of their loans — and some banks have done so. Butthe restructuring process is often complicated, ties up bankresources and is time consuming. Selling can offer a moreefficient, faster solution. As another alternative to selling, bankshave shored up balance sheets and increased capital reserves,for example, by issuing shares or converting lower-qualitycapital to common equity.35But that still leaves them with theproblem of what to do with their NPLs.The bad bank optionOne solution currently in favor by some countries is to establisha government-sponsored bad bank, where the troubled financialinstitutions contribute their NPLs and other troubled loans tothe bad bank, thus cleansing their balance sheet of these loansand freeing the bank from the distraction, costs and use ofresources inherent in managing a portfolio of troubled loans. Ofcourse, this strategy does little to reduce the overall exposureto NPLs at the country level, since they still exist in the system,albeit not at the banking level. Nevertheless, the strategyhas merit. Rather than individual banks implementing manydifferent strategies to resolve their NPL problems, the bad bankcan plan and execute an orderly disposition of the NPLs receivedfrom multiple banks, whether at auction or through directnegotiations or other strategy.Holding NPLsAgainst the reasons to sell, banks also have reasons to keepNPLs on their balance sheets. In selling, banks would likely haveto recognize losses that would reduce their capital and cut theirprofits. Undercapitalized banks with thin profit margins mightnot be able to absorb such losses.The European Central Bank’s (ECB) program to provide cheapfinancing to some of the region’s largest banks has reduced thepressure on these banks to sell bad loans. While the ECB’s moveswere designed to prevent a credit crisis and further weakeningof the European economy, market analysts are concerned thatbanks will leave capital tied up in non-performing loans andassets in a process known as “pretend and extend.” This couldleave some banks unable to provide enough credit to meet theordinary needs of companies, businesses and other borrowers.36In January 2013, the Basel Committee on banking supervisionconfirmed that it had given lenders four more years to put inplace the new liquidity coverage ratio (LCR). In 2015, banksmust have only 60% of the LCR in place instead of the original100%. They will have four more years, or until 2019, to meetthe 100% requirement.37The purpose of the rule change is to
13 Flocking to Europe Ernst & Young 2013 real estate non-performing loan reportensure that banks have enough liquid assets to meet a short-term market crisis. It could also give banks more time to workout, restructure or sell their NPLs rather than taking moreimmediate action.Pricing issuesPricing issues are keeping some banks from selling NPLs. Banks,of course, try to secure the highest possible prices in order tomaximize their recovery and minimize their losses from NPLsales. But some investors say banks have overpriced assetsgiven the current weakness in Europe’s economy, the generallevel of commercial property values, and the risks and coststo investors in performing due diligence and repositioning theunderlying collateral for restructuring and future sale. Anotherchallenge for investors lies in dealing with different legalsystems in countries where they invest. Nevertheless, deals aregetting done, but with a wide range in pricing. In the UK andIreland, NPLs sold last year for 20% to as much as 90% belowoutstanding claim amount.NPL sales activity picking upSo far, some of the largest sales of distressed loans have beenby banks in the UK and Ireland. Among other reasons, investorshave focused on these countries because of the relative ease ingetting to the underlying collateral, unlike some other countrieswhere, for example, foreclosures take a longer time periodto complete.38This year, NPL sales activity is picking up as European banksfocus on deleveraging their balance sheets. In addition to sellingportfolios of NPLs only, some banks are retrenching and sellingso-called non-core portfolios consisting of a mix of performing,subperforming and non-performing loans collateralized byproperties that typically are in regions outside the bank’s coreoperating geography. Banks also are selling loans on singleproperties, which could help to attract investors that might notbid on large portfolios.NPL marketsGermanyGermany developed into a mature NPL market during the 2003to 2007 period, before the global recession and financial crisishit. Today, it has the necessary legal framework and advisor andservicer network to attract international investors and support ahigh volume of NPL transactions. However, while a small numberof larger NPL transactions were completed during the past twoyears, overall market activity has so far remained unexpectedlylow considering the amount of NPLs on the books of Germany’sbanks. At the end of 2012, German banks held an estimated€200 billion of NPLs. This year, because of increased NPL salesactivity and an improving Eurozone economy, the banks’ NPLsare expected to decline to €183 billion in 2013, according tothe 2012–13 winter edition of the Ernst & Young EurozoneForecast.39But that would still leave a significant amount ofNPLs weighing down the German banking system.Banks have been reluctant to sell NPLs partly because of theuncertainty created by the global financial crisis and Eurozonecrisis of recent years. Furthermore, almost all German privatebanks and Landesbanken have been forced to deleverage andshrink their balance sheets to reach or maintain Basel III corecapital ratios. In the course of deleveraging, banks have so farheld on to their NPLs until investor pricing is more in line withbank carrying values.While banks have refrained from selling NPLs, they havebeen working on improving their core capital ratios, graduallyadjusting their loan book values to reflect investor pricing,and restoring or maintaining profitability. Most banks haveset up internal restructuring units to work out or sell NPLsas well as dispose of non-core parts of their businesses. Inaddition, two German bad banks have been incorporated (FMSWertmanagement and EAA). They hold assets transferred fromHypo Real Estate (FMS) and WestLB (EAA) to resolve largepools of non-core and non-performing assets over a 15- to20-year period. Their strategy so far has been more focused onresolution solutions other than sales, although the bad banksare expected to become more active in selling non-core and non-performing assets in the years to come.In 2013, conditions could be more favorable for the saleof NPLs. The support of the European Central Bank for theEurozone has calmed financial markets. Most banks are inthe process of completing strategic realignments, while usingthe cheap liquidity provided by the central bank to improveprofitability and core capital ratios. The value of the real estatecollateralizing NPLs is increasing on the overall strength ofGerman property markets. Germany is attracting more propertyinvestment from international and domestic investors seekinghigher yields and a safe haven. The gap between NPL bid andask prices could narrow if the strength of German banks andproperty markets gives investors confidence to pay higher pricesfor NPL portfolios.In February 2013, Lloyds Bank of the UK sold the first sizableportfolio of non-performing loans secured by German retail realestate collateral. This transaction, with a face value of €850million, drew a number of global investors who competed tosecure the deal. While too soon to tell, this deal may come to bethe icebreaker transaction that will motivate a large number ofGerman banks to test the market for NPL sales.
14Flocking to Europe Ernst & Young 2013 real estate non-performing loan reportUK and IrelandIn 2011, an NPL market began to take shape in the UK andIreland. While there has not been the wave of transactions thatsome market analysts anticipated, nine transactions totalingmore than €8 billion were completed between July 2011 andSeptember 2012,40and more have been completed since then.In January 2013, Fitch Ratings said in a report that majorUK banks are generally soundly capitalized, but they needto continue deleveraging and restructuring to meet BaselIII targets. It took note of banks’ risk exposure to souredcommercial real estate loans, saying many may need to berenegotiated or sold in the near future.41Ireland’s property markets are showing signs of recovering.Property prices are expected to bottom out in 2013. Ireland’sstate-owned banks reportedly are speeding up the sale of tensof billions of euros’ worth of property-backed loans.42In a moveto help prop up the banking industry and to facilitate the orderlydisposition of troubled loans, Ireland created a bad bank knownas the National Asset Management Agency (NAMA) in 2009.The agency has acquired €74 billion of loans from participatingfinancial institutions. As of year-end 2012 it had disposed of€6.9 billion in assets.43In early February 2013, the European Central Bank cleared aplan for Ireland to liquidate the former Anglo Irish Bank nowknown as IBRC. Under the plan, the debt taken on by the IrishGovernment to finance Anglo Irish’s rescue will be swapped forlong-term government bonds.44The government initiated theliquidation to reduce the burden of €31b in promissory notes,a form of an “IOU” given to IBRC to allow it to borrow from theCentral Bank of Ireland.45Domestic as well as international banks are selling real estateloan portfolios, including portfolios of distressed property loans.In November 2012, Apollo Global Management reportedlypaid £149 million to buy a portfolio of distressed commercialproperty loans in Ireland from Lloyds Banking Group. Lloydshas taken an aggressive approach to unwinding a reported£24 billion of non-performing property loans; in the first ninemonths of 2012 it reduced its real estate exposure by a reported£4.1 billion.46SpainWhile currently not attracting as much interest from NPLinvestors as other countries, Spain could become one of themost active NPL markets. With Spain’s economy expected toremain in recession throughout 2013, it is likely that NPLswill continue to climb.47Today, Spain has one of the largestexposures to NPLs, with about €190 billion in troubled loans.Yet transactions have been limited. However, recent regulatoryreforms have had the effect of enabling NPL transactions atlower prices, and bid and ask spreads are narrowing, helpingto enable sales. Also helping sales are deal structures in whichbanks share the risks with buyers in resolving the loans, such asthrough workouts and restructures.Spain’s Government has created SAREB, a bad bank designedto acquire NPLs from the country’s banks. With SAREB in thestart-up stage, it’s too early to know its impact on the country’sNPL problem. But expectations are high, and opportunities forinvestors will likely follow. SAREB has begun the processof buying up to €90 billion of NPLs and other assets frombanks. SAREB plans to sell the assets to investors over a long-term period.
Lee Millstein is Head of European and Asian Distressed and RealEstate Investments and Senior Managing Director of CerberusCapital Management.In an interview, Millstein discussed opportunities to invest inNPLs in Europe, the investment outlook in Europe and how theEuropean NPL market compares with the US market.How do opportunities to invest in NPLs in Europe comparewith the rest of the world? Right now, Europe represents thebiggest NPL opportunity worldwide. In my view, EuropeanNPLs are one of the best investment opportunities of anyasset class globally.Why? That assessment is based on the significant size ofEurope’s banking system compared with the Europeaneconomy, the shortage of capital in the banking system,the size of the NPL market, the state of the Europeaneconomy and other criteria.What’s the size of the European NPL market? Between €3trillion and €3.5 trillion of total non-core assets, including over€1 trillion of NPLs. If you assume these numbers, and compareit with NPL sales to date, sales activity has been moderate. Butthere are numerous signs that it is picking up rapidly.How did you arrive at the more than €1 trillion figure? It’sderived from a country-by-country analysis of the NPL market.It’s based on information that’s publicly available, talking withpeople in the market, our long experience in this market andother sources. If anything, that estimate might be understated.What’s this year’s outlook for NPL sales in Europe? Sales in2012 were probably 40% higher than in 2011. Looking ahead,2013 is shaping up to be bigger yet.What’s the basis for your outlook? It’s based on NPLs in thepipeline, deals under discussion, deals that have already beenawarded in the first few weeks of 2013, in-depth discussionsdirectly with selling banks, as well as advisors and others. Likeany great opportunity, the European NPL pipeline isn’t growingas big as investors likely prefer today, but it is moving in theright direction. Banks and regulators realize that NPL deals arethe only solutions that work for everyone.Are you focused on investment opportunities in particularcountries in Europe? There are five countries where we areexamining opportunities very closely: Germany, UK, Ireland,Spain and Italy. Our primary focus has been on the UK andGermany, and will likely remain so for the next 12 months,based on the deals we’ve done, our deal pipeline and where wesee the best opportunities. But activity in Spain and Ireland isgrowing rapidly.In Europe’s commercial real estate sector, what types ofloans are you interested in? We look at everything. We investin a wide range of loans, including residential, consumer,corporate, commercial and industrial, secured, unsecured andothers. We will consider investing in smaller loan portfolios aswell as in the largest.How about deal size? We look at the entire range. We’ve lookedat deals as small as US$25 million to US$50 million. We’ve alsodone a number of deals between US$300 million to US$500million, and some above US$500 million.What pressure is there on European banks from governmentsand the market to move NPLs off their books? The pressurein Europe is coming from several fronts. First, banks will have togradually meet the new Basel III minimum international capitalrequirements, which make it very capital intensive to hold NPLs.Second, it’s costly for banks to keep NPLs on their balancesheets. NPLs generate zero income, and the banks typicallydon’t have experienced workout platforms. So it’s better forthe banks, better for us since we know how to do workouts,and it’s better for the underlying market. It’s a win-win. Third,regulators in Europe and elsewhere realize that banks aren’t thebest holders and servicers of NPLs. A good example of that iswhat happened in Asia in the 1990s. The European banks havelearned that lesson and understand moving first and fast is totheir benefit.Why Asia? In Asia, Japanese banks held their NPLs for avery long time, and when they finally did sell, it was at deeplydiscounted prices. Korean banks moved NPLs off their booksmore quickly, and at far better prices.Interview with Lee Millstein, Cerberus Capital Management15 Flocking to Europe Ernst & Young 2013 real estate non-performing loan report
Flocking to Europe Ernst & Young 2013 real estate non-performing loan reportIrish banks and some other European banks have been sellingforeign assets, including NPLs and other non-core assets.Do you expect this trend to continue? A lot of banks areretrenching to their home markets. They want to concentrateon addressing NPL problems in non-core markets. It’s acontinuing trend.What returns do you anticipate from your investments inEurope? It’s too early to say what they will be. We’ve had thesame teams working on NPLs globally for more than 10 years,and returns to date in Europe have been more than satisfactory.How long do you expect to continue to have investmentopportunities in Europe? Compared with the Asian NPL marketof the past, Europe’s NPL problem today is probably twicethe size of Asia’s. In Asia, there was a steady flow of NPLs forsix straight years. In Europe, I would expect the deal flow tocontinue for another three to five years.Are there any opportunities for small US investors to getinto the European NPL market? This is not an investmentfor small US investors. There are two ways to do deals: atauctions or in negotiated deals. On the auction front, mostinvestors are maintaining discipline. If more than three or fourinvestors are invited, most investors have the good judgmentnot to participate.How about on the negotiated deal side? As for negotiateddeals, banks want investors that they know, with a track recordof creative solutions to NPL problems, that have the capital, andcan help manage the assets and maintain confidentiality. Whatall this means for small US investors is that it is very difficult tobreak into the European market in competition with firms likeours that have been in the NPL market for a long time and havelarge dedicated teams to underwrite, acquire and service theNPLs. It’s hard for any new entrant to build relationships withbanks considering that we’ve had those relationships for years,have large amounts of capital to invest and have a proven multi-year track record in this asset class.16
17 Flocking to Europe Ernst & Young 2013 real estate non-performing loan reportOverviewInvestment activitySurvey respondents expect the US NPL market to remainactive, but for a shorter time period than they did a year ago.More respondents to this year’s report said they expect themarket to remain active for 12 to 18 months; a year ago,many respondents thought it would stay active for 24 to 36months. As in past surveys, investors said their first choice foraccessing the market is through off-market transactions ordirect negotiations.About a third of investors said they have shifted their primaryfocus to Europe, which is emerging as the world’s largest marketfor distressed loans. Investors targeting Europe are primarilyinterested in NPL investment opportunities in Germany, the UK,Ireland and Spain. More than half of them expect the Europeanmarket to remain active for 36 to 48 months.Capital allocationMore investors said they have allocated less than US$100million for investment in NPLs this year. This may be becausethey expect to invest less in NPLs in 2013, and they aredirecting their investments more toward buying smallerportfolios from regional or local banks. Investor allocations ofmore than US$100 million to more than US$1 billion are aboutthe same as a year ago.Deal sizeFewer investors are seeking deals of less than US$50 million,while more investors are looking for deals in the US$50 million–US$100 million range. Investors who plan to allocate less thanUS$100 million of capital in NPLs this year may prefer dealsin this range to transactions of less than US$50 million. Fewerinvestors are seeking deals in the US$100 million–US$500million range, perhaps because not as many investors have thecapital to buy NPLs in this range, or there simply were fewerdeal opportunities. About 8% of respondents, presumablyincluding the biggest NPL investors, are looking for deals ofUS$1 billion or more.LeverageInvestors appear to be putting more equity into transactions. All-cash buyers increased in our latest survey, and the percentageof investors using less than 50% leverage increased while thoseusing more than 50% declined.Investment returnsInvestors appear to have lowered their return expectationssomewhat, possibly because values of the properties underlyingNPLs have been improving along with a general recovery incommercial property prices, and NPL yields are declining. Moreinvestors are seeking 10%–15% returns, and fewer are lookingfor returns of 20% or more. Those targeting 15%–20% returnsremained about the same as a year ago.Survey findings
18Flocking to Europe Ernst & Young 2013 real estate non-performing loan reportSurvey findings: the details1. Investment activityThe survey asked respondents how “active” they were, meaning the time, effort and resources they areputting into seeking opportunities to acquire distressed loans. In 2010, only 5% of survey respondents saidthey were less active than a year ago. That figure has increased every year since then. In 2013, it reached30% for the first time. Correspondingly, there has been a decrease in respondents who were more active, from49% in 2010 to about 32% in 2012. Respondents who said their investment activity was about the same as ayear ago declined to about 38% in 2012. In previous surveys, it was 46%.Question 1: What is your NPL portfolio-activity level compared with 12 months ago?2013 comparedto 12 months ago2012 comparedto 12 months ago2011 comparedto 12 months ago2010 comparedto 12 months agoSame 38% 46% 46% 46%More 32% 26% 35% 49%Less 30% 28% 19% 5%Source: Ernst & Young LLPtroubleshooting, abs, Due Diligence, workplace, credit, Property-Management, Immobilie, NPL,Rating, Real-Estate, Conact, conactor, Bad-Bank, Servicing, interim, turnaround, Cashflowsync,CCFS, Distressed Asset, CMBS, portal solution, ICD, Kowollik, recupero di credito,datawarehouse, cloud-solution, Workout, Incentive Care, Institutsverwaltung, distressed,Orgaplan Italien, Special Servicing, DocRating, DueDiligence, Draftcheck, Lucidi, welltbuero,Immobilienkongress, Audis, compliance, Ardea, NPL-Forum2012, risorse per ROMA SPA, RpR ,protocollo di qualitá, capitale Roma, Aareal, Immoconsulting, Teramo, workplace management,closing, interim, orgaplan, restructuring, fallimento, fallimentare, upgrading, turnarond,
19 Flocking to Europe Ernst & Young 2013 real estate non-performing loan report2. Capital allocationAbout a third of survey respondents have allocated less than US$100 million for the purchase of NPLportfolios in 2013, up from 23% in last year’s survey. In other categories, planned allocations areabout the same as a year ago. More investors are specific about their plans this year: only 23% saidthey haven’t allocated a specific amount for investment in 2013. Last year, nearly a third hadn’t decidedon an allocation amount.Question 2: How much capital has your company allocated for the purchase of NPLportfolios in 2013?2013 2012 2011 2010None — no plans to invest in NPL portfolios 9% 12% 14% 25%Less than $100 million 33% 23% 19% 43%$100 million to less than $500 million 22% 21% 27% 27%$500 million to less than $1 billion 8% 7% 3% 3%$1 billion or more 5% 5% — 2%Do plan to invest in NPL portfolios, but no specific amount allocated. 23% 32% 37% —Source: Ernst & Young LLP3. Method of buying loan portfoliosAs in 2012, respondents most often are accessing the NPLs market through off-market transactions anddirect negotiations, followed by broadly marketed offerings by sales agents (sealed bid auctions). Respondentswere least likely to use online auctions, which was also true in previous surveys. Some respondents said theyused other means to access the market, such as loan servicers, investment bankers or direct negotiationswith owners.Question 3: How are you accessing the market for NPLs? (Please rank from 1 to 4, with 1 being the most frequent.)2013 2012Using online resources such as internet auction sites 2.84 3.18Off market transaction sources and direct negotiations 1.41 1.56Participating in broadly marketed offerings by sales agents (multiple bid) 2.33 2.22Other 3.42 3.08Source: Ernst & Young LLPAsset, CMBS, portal solution, ICD, Kowollik, recupero di credito, datawarehouse,cloud-solution, Workout, Incentive Care, Institutsverwaltung, distressed, Orgaplan Italien,Special Servicing, DocRating, DueDiligence, Draftcheck, Lucidi, welltbueroTreuhand Intesa Unicredit Immobilien Ubibanca ByYou Jerome Chapuis First AtlanticRicucci EH-Estate Fortress condominio amministrazione immobiliare condominialeintegrazione sincronizzazione ruoli immobiliare millesimo conto economico Fondoimmobiliare IAS/IFRS commercialista KMPG Deloitte revisione MPS Unicredit SGR Bancad`Italia Legge 106 cartoliarizzazione Reo Immobilie imueble Casa Recupero Credito BadBank SIP Sistema integrada protection Caja workout Credito fallido credits en détresseTroubelshooting incentive care ICD Pfandbriefbank Eurohypo Portfolio ; Exit - StrategiaImmobilienfond Software Orgaplan CONact Unicredit CashflowSync RE-lifecycle Kowollikdeuda morosa UEN Union Estates Network lucidi vendittelli UCCMB italfondiario DueDiligence Portal-Software Web-Solutions Property
20Flocking to Europe Ernst & Young 2013 real estate non-performing loan report4. Europe draws interest; US remains primary marketWith the growing investor interest in Europe’s NPL market, we added questions about Europe in our currentreport. About 30% of respondents said Europe will be their primary focus in 2013, and some said the UKspecifically. About two-thirds of respondents said they will focus on the US. A few said Asia.Question 4: For your company, what market is the primary focus for NPLs over the next 12 months?US Europe Asia Americas non US65.6% 31.1% 3.3% 0.0%Source: Ernst & Young LLP5. European investors target Germany, UK, Ireland and SpainOf the investors primarily focused on Europe this year, nearly half said Germany was their target market, morethan a third said the UK, about 33% said Spain and 30% Ireland.Question 5: In which countries in Europe is your company focused on purchasing NPLs over the coming 12 months? (Choose all that apply.)Countryover the coming12 monthsCzech Republic 4%Germany 46%Greece 4%Hungary 2%Ireland 30%Italy 9%Poland 6%Romania 2%Russia 4%Spain 33%Turkey 2%United Kingdom 39%Not interested in European NPLs 41%Other (please specify) —Source: Ernst & Young LLP
21 Flocking to Europe Ernst & Young 2013 real estate non-performing loan report6. Deal sizeSince we began our survey, the biggest change in deal size has been in the percentage of investors seekingdeals of US$50 million or less. At 60% in our 2010 survey, that percentage declined to 35% in our latestsurvey. Investors seeking deals of US$50 million–US$100 million increased in our latest survey to 23% from20% a year earlier. Investors interested in deals of US$100 million–US$500 million declined to 16% from20% a year ago. Those seeking deals of more than US$500 million increased to 8% from 4%. A slightly lowerpercentage of respondents are unsure about the deal size they want.Question 6: What deal size are you interested in?2013 2012 2011 2010$500 million or more 8% 4% 3% —$100 million to less than $500 million 16% 20% 22% 18%$50 million to less than $100 million 23% 20% 16% 22%Less than $50 million 35% 36% 43% 60%Not sure or depends 18% 20% — —No plans to invest in NPL portfolios — — 16% —Source: Ernst & Young LLP7. Investment return requirements (unleveraged internal rate of return)About half of the survey respondents said they are looking for returns of 16%–20%, the same as a year ago.Those seeking returns of more than 20% declined to 22% from 25% a year earlier. The biggest change camein the percentage of respondents seeking returns of 10%–15%. That percentage increased to 29% in our latestsurvey from 20% a year ago.Question 7: What are your investment return requirements (unleveraged internal rate of return)?Investment return requirements 2013 2012 2011 2010below 10% — 3% — 2%10% — 15% 29% 20% 30% 40%16% — 20% 49% 52% 62% 42%above 20% 22% 25% 8% 16%Source: Ernst & Young LLP
22Flocking to Europe Ernst & Young 2013 real estate non-performing loan report8. Leverage requirementsAbout 63% of respondents said they use some leverage, compared with about 67% year ago. But investorsappear to be using less leverage. Some 25% of investors said their leverage requirement is 51%–60%, downfrom 33% a year earlier. By contrast, 20% of investors require 26%–50% leverage, up from 15% a year ago.Those who indicated they were all-cash buyers increased to 37% from 33% the previous year.Question 8: What is your leverage expectation or requirement?Leverage 2013 20120% — all cash buyer 37% 33%1% — 25% 3% 5%26% — 50% 20% 15%51% — 60% 25% 33%61% — 70% 13% 9%above 70% 2% 5%Source: Ernst & Young LLP9. US NPL market outlookRespondents to this year’s survey shortened theirtime frame for how long they think the US NPLmarket will remain active. About 20% expect it toremain active for up to 18 months vs. 4% a yearearlier. Only about 13% expect it to remain activefor up to 36 months vs. 29% a year earlier. Only 5%see it staying active for 48 months.Question 9: How long do you think the US NPL market will be active?2013 2012No longer active 3% —Next 12 months 14% 4%Next 18 months 20% 14%Next 24 months 22% 36%Next 36 months 13% 29%Next 48 months 5% 17%No opinion 23% —Source: Ernst & Young LLP10. European NPL market outlookBased on responses to this year’s survey, investorsthink the European NPL market will stay activelonger than the US NPL market. More than half therespondents said the European market will stayactive for 36 to 48 months. Only about 8% said itwill remain active for up to 24 months. The rest hadno opinion.Question 10: How long do you think the European NPL marketwill remain active?2013Next 12 months 0%Next 18 months 4%Next 24 months 8%Next 36 months 22%Next 48 months 33%No opinion 33%Source: Ernst & Young LLP
In a recent interview, David Abrams and Steve McElwain of ApolloManagement International, LLP, discussed the outlook for distresseddebt markets in Europe. Based in London, Abrams is Senior PortfolioManager of Non-performing Loans at Apollo Management Internationaland Managing Partner and Co-Founder of Apollo European PrincipalFinance Fund. McElwain is a Principal with Apollo European PrincipalFinance Fund.What’s your assessment of the size of Europe’s distressed debtmarket? We estimate it’s about €1.5 trillion – about €750 billion ofNPLs and €750 billion of performing and non-performing, core andnon-core assets.Where is Europe in terms of resolving its distressed loan problem?We believe Europe is in the early stages of resolving what appears tous as a very large problem with respect to distressed loans. Very few ofthese problem loans have been sold, and we believe banks will be sellingloans for some time to come.What’s the outlook for Europe’s distressed debt pipeline in 2013?We believe Europe will attract more investment from investorsworldwide, and the pipeline is expected to continue to grow over thenext few years. The forced liquidation of assets by bailed-out banksshould continue. Banks are trying to manage new capital requirementsand address liquidity issues, and they are seeking creative solutions totheir problematic distressed loans. We believe this dynamic should resultin fewer auctions and more direct negotiations for the sale ofloan portfolios.Will banks be selling assets other than distressed loans? From ourperspective, yes —we believe sales will not be limited to only distressedloans. We are seeing banks and other financial institutions, not just inEurope but elsewhere around the world, looking for ways to exit fromasset classes that no longer fit within their core areas of focus.How much capital has Apollo raised for investment in EuropeanNPLs? We raised approximately €1.3 billion for our first fund, whichis almost fully invested. We recently held the final fundraising for oursecond fund, Apollo European Principal Finance Fund II, or EPF II, whichraised about €2.5 billion. We are actively evaluating opportunitiesthroughout Europe to identify opportunities to deploy the capital raisedin EPF II.Where are you investing in Europe? Although we target investmentsacross Europe, we have focused on four markets: Germany, the UK,Spain and Ireland. We seek to deploy our funds’ capital with the aimof optimizing the outcome of the investments that are made — andwe take an active role once our funds invest in an asset. The fundswe manage typically own the servicers in each market in which we’reactive, and we believe that banks appreciate the fact that we conductour own servicing. In many cases, we have found that the banks andother financial institutions we are engaged in dialogue with are lookingto redeploy their internal resources and would prefer to avoid having todeal directly with managing bad loans.In addition to NPLs, are you buying performing assets? Over thepast two years, we believe Apollo has been one of the largest investorsin performing consumer debt in Europe.We continue to evaluate other performing asset classes, but in mostcases the pricing hasn’t met our return requirements. One of the mostsignificant variables is leverage. In the current environment, manyinvestors are taking advantage of low rates to obtain financing andinvest in deals. And some investors, rather than investing equity, areentering the market and providing financing for deals.Are you buying through the auction process as well as directnegotiations? Some deals are widely marketed through auctions, but inthese types of situations valuations can be driven up, and we more oftenthan not get priced out of a deal. We generally prefer direct negotiationswith banks and other financial institutions, where we believe we canprovide a quick and holistic solution to the seller.Have you done any joint ventures? Yes — we have participated in somejoint venture transactions, and, generally speaking, they have beensuccessful. We have found that in certain situations, while banks mayprefer to fully dispose of a portfolio of loans, for one reason or another,they are unable to sell the entire portfolio up front and instead theyare comfortable to share in the risks of servicing the loan portfolio andseeking to recover the value of the loans.Are you interested in buying assets other than real estate? Yes.Although loans secured by real estate remains our primary focus, wecontinue to look for opportunities to expand our footprint in performingconsumer receivables. In addition, today there are opportunities inalternatives such as rolling stock and shipping in specific markets.Regardless of the asset, our decision to invest the funds we managedepends on whether we believe we can price the asset competitively,service it efficiently and meet our funds’ return requirements.Interview with David Abrams and Steve McElwain,Apollo Management International23 Flocking to Europe Ernst & Young 2013 real estate non-performing loan report
25 Flocking to Europe Ernst & Young 2013 real estate non-performing loan reportSurvey questions and responsesSame38.1%Less30.2%More31.7%What is your NPL portfolio-activity level comparedwith 12 months ago?Less than$100 million32.8%$500 millionto less than$1 billion7.8%$100 to lessthan $500 million21.9%How much capital has your company allocated forthe purchase of NPL portfolios in 2013?None - no plansto invest in NPLportfolios.9.4%$1 billion or more4.7%Do plan toinvest in NPLportfolios, but nospeciﬁc amountallocated23.4%How are you accessing the market for NPLs?(Please rank from 1 to 4, with 1 being the mostfrequent.)Using onlineresources suchas internetauction sites2.84Off-markettransactionsourcesand directnegotiations1.41Participatingin broadlymarketedofferings bysales agents(multiple bid)2.33Other3.42$500 millionor more8.1%Less than$50 million35.5%Not sureor depends17.7% $100 millionto less than$500 million16.1%$50 millionto less than$100 million22.6%What deal size are you particularly interestedin? (Select one.)For your company, what market is the primary focusfor NPLs over the next 12 months?Americasnon-US0.0%Europe31.1%Asia3.3%US65.6%For your company, what market is the primary focusfor NPLs over the next 12 months? (Choose all that appy.)Not interestedin European NPLs40.7%Italy9.3%United Kingdom38.9%Germany46.3%Spain33.3%Ireland29.6%Poland5.6%Russia 3.7%Greece 3.7%Czech Republic3.7%Turkey 1.9%Romania1.9%Hungary1.9%Other 0.0%Source: Ernst & Young LLP Source: Ernst & Young LLPSource: Ernst & Young LLP Source: Ernst & Young LLPSource: Ernst & Young LLP Source: Ernst & Young LLP
26Flocking to Europe Ernst & Young 2013 real estate non-performing loan reportno longer active —it has run its course3.1%for the next18 months20.3%For the next12 months14.1%No opinion23.4%How long do you think the US NPL market will be active?For the next24 months21.9%For the next48 months4.7%For the next36 months12.5%For the next36 months21.9%For the next48 months32.8%No opinion32.8%For the next18 months4.7%For the next12 months0.0%For the next24 months7.8%How long do you think the European NPL market willremain active?0% leveraged —all cash buyer37.3%1%–25%leveraged3.3%26%–50%leveraged19.7%51%–60%leveraged24.6%61%–70%leveraged13.5%More than70% leveraged1.6%What is your leverage expectation/requirement?What are your investment return requirements(unleveraged internal rate of return)?IRR below 10%0.0%IRR 10%–15%28.6%IRR above 20%22.2%IRR 16%–20%49.2%Source: Ernst & Young LLP Source: Ernst & Young LLPSource: Ernst & Young LLP Source: Ernst & Young LLP