flocking to europe -

Flocking to Europe Ernst & Young 2013 non-performing loan 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 report

Welcome to our fifth NPL investor survey Only a year or so ago, global investors in distressed loans were primarily focused on the US. Today, as our latest survey attests, investors increasingly are seeking investments in Europe’s emerging market for distressed debt. They also continue to look for investment opportunities in the US. Although the US distressed loan market has slowed, the market still offers ample investment opportunities, according to investors who participated in our current survey. In fact, almost 70% expect the US market to remain active over the next 12 to 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 Federal Deposit Insurance Corporation’s (FDIC) fourth quarter banking data paints a picture of a stable and steadily improving banking industry. In commercial real estate, the heady growth enjoyed by certain property types and locations has allowed certain borrowers to keep their loans current, continue to invest in their properties and take advantage of refinance opportunities.

However, issues remain. Property values have increased mainly in key US markets for high quality assets. Elsewhere in the US, values remain depressed and borrowers continue to struggle. Real Capital Analytics reports that US$164 billion in commercial real estate mortgages remain distressed. Furthermore, tens of billions in looming maturities are a constant threat to both borrowers and lenders because depressed property values limit borrowers’ ability to refinance, increasing the risk of default at maturity.

As for banks, commercial real estate (CRE) loans constitute only 7% of the total assets of big banks. However, for banks with US$10 billion or less of assets, CRE loans account for a disproportionate 26% of total assets. These banks will likely focus on reducing the percentage of CRE loans on their balance sheets through sales and other measures, which could 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’s no secret that the US nonperforming loan market has not lived up to the expectation of these investors. In the meantime, European banks have increasingly begun to reduce their exposure to NPLs via portfolio sales. Consequently, global NPL investors are turning their attention to Europe, and for good reason. An estimated €1 trillion of NPLs are sitting on the 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. Their consensus is that the markets with the most opportunity are the UK, Ireland, Germany and Spain. And investors are taking the long view. As one notes, “we believe Europe is in the early stages of resolving what appears to us as a very large problem with respect to distressed loans.” For the first time since the global financial crisis and property market downturn, investors now have opportunities on both sides of the Atlantic.

As always, we would like to thank the investors who participated in our survey. We very much appreciate your perspectives on the changing market.

Christopher Seyfarth Partner, Ernst & Young LLP

Howard Roth Global Real Estate Leader

Flocking to Europe Ernst & Young 2013 real estate non-performing loan report

Although the US NPL1 market remained active in 2012, there may have been less investment activity simply because there were fewer investment opportunities. The FDIC was not as active in selling loans. The amount of net NPLs in banks’ portfolios has been declining (see “Distressed loans,” page 6), which suggests that banks have fewer NPLs to sell, although a substantial amount remains on their books. Some NPL transactions were not completed because investors and banks could not agree on price, and some banks simply stayed out of the market.

Nevertheless, our survey respondents said they expect the US NPL market to remain active, although for a shorter time frame than they anticipated a year ago. The US economy continues its slow but steady growth, commercial property markets are improving and property values are rising. These developments should help bridge the pricing gap between sellers and 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 maturing over the next few years — and the risk that this might result in an increase in their NPLs. That risk might motivate banks and special servicers2 to accelerate sales of their existing NPLs as well as subperforming loans.

Meanwhile, Europe is emerging as an NPL market in its own right, with an estimated €1 trillion of NPLs on the balance sheets of the region’s banks. In addition to local investors, the market is drawing more investment from international investors, with NPLs collateralized by commercial properties in Germany, the UK, Ireland and Spain currently attracting the most interest. Sales of NPLs could increase in 2013 as sellers take advantage of the demand and investors grow more confident in the stability of Europe’s economy and the euro and are therefore more able to meet sellers’ price expectations. Sales activity is in its very early stages, however, and banks could be selling NPLs for some time to come.

In this year’s report, we look at the NPL investment markets in the United States and Europe and how our survey respondents view investment opportunities in the two markets. For the first time, our survey includes European investors, who constituted nearly 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 report

BanksBy many measures, FDIC data shows that banks have returned to profitability and their balance sheets are strengthening:

2012 earnings increase 19.3% to US$141.3 billion, the second-highest amount ever

The banks’ 2012 earnings were about US$4 billion less than the record US$145.2 billion in 2006. The largest contribution to the increase in 2012 earnings came from reduced provisions for loan losses, which fell by US$4.9 billion (or nearly 25%) from 2011.

Fourth quarter 2012• ProfitsincreasemorethanathirdoverQ42011

Insured banks and savings institutions earned US$34.7 billion in Q4 2012, a 36.9% increase from Q4 2011 and the highest fourth-quarter total since 2006. Well over half of all institutions (60%) reported higher earnings than a year earlier, and only 14% reported losses, down from 20% a year earlier. Reduced expenses for loan losses and rising noninterest income accounted for most of the year-over-year improvement in earnings.3

United States• Loan loss reserves decline 25%

Banks’ loan loss reserves were US$15.1 billion in Q4 2012, or nearly 25% less than the US$20.1 billion in Q4 2011, marking the 13th consecutive quarter that the industry’s reserves have declined.

• Net loan charge-offs decline Banks’ net loan charge-offs (NCOs) also declined in Q4 2012, to US$18.6 billion, or 27%, from US$25.6 billion a year earlier, making it the 10th consecutive quarter NCOs have declined. All major loan categories improved from the prior year. In real estate construction and development, NCOs declined by US$1.3 billion, or nearly 63%.

• Bank failures fall The number of bank failures fell to 51 in 2012 from 92 in 2011.4 The number of failures in 2012 was about a third of the 157 failures in 2010, which was a nearly 20-year high.

• Number of problem banks declines sharply The number of banks on the FDIC’s “problem list” declined in Q4 2012 to 651 from 813 in Q4 2011. This marked the seventh consecutive quarter that the number of “problem” banks has fallen, and the first time in three years that fewer than 700 banks were on the list. Total assets of “problem” institutions declined to US$233 billion from US$319 billion a year earlier.

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Bank earnings 1Q07- 4Q12Quarterly profits continue to improve

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Bank earnings 1Q07–4Q12 Quarterly profits continue to improve

3 Flocking to Europe Ernst & Young 2013 real estate non-performing loan report

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Loan loss provisions 1Q07- 4Q12Expenses for bad loans fall again

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Net loan charge-offs 1Q07- 4Q12Loan losses improve across most loan categories

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Net loan charge-offs 1Q07–4Q12 Loan losses improve across most loan categories


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“Problem” banks 1Q07- 4Q12Numbers of “problem” banks and bank failures decline

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Number of institutions on the FDIC’s problem list declined for seventh consecutive quarter

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“Problem” banks 1Q07–4Q12 Numbers of “problem” banks and bank failures decline


RisksUS banks turned in a very strong performance in the fourth quarter of 2012 and for the entire year, continuing a trend of positive earnings that began nearly three years ago. However, their problems with non-performing loans are not behind them — yet.

• Non-current loan balances remain high Despite a reduction in non-current loans to US$276.8 billion from US$292.8 billion at the end of the fourth quarter, such loans are still about 2.5 times higher than when the recession started in December 2007.

• Nearly half of all banks added to loan loss reserves While banks’ total loan loss reserves declined by nearly 25% or US$4.9 billion in Q4 2012, to US$15.1 billion, much of the reduction was concentrated in the larger banks. Nearly half of all institutions added to their reserves in the quarter.

• Maturing loans remain an issue Maturities continue to be problematic for banks and special servicers. (See “Maturing CMBS loans,” page 8.) The problem is that many of the banks’ outstanding CRE loans do not meet their current underwriting standards. For banks, the challenge is how to best deal with this risk exposure as these loans mature.

• Number of problem banks declines but is still relatively high Although 651 problem banks were on the FDIC’s watch list at the end of 2012, down sharply from 813 a year earlier, that number was still much higher than in 2006, before the financial crisis, when there were only 50 problem banks.

• Loan-to-deposit ratios decline The banking industry’s loan-to-deposits ratio declined in 2012 to 72% from 95% in 2007. Deposits reached a record US$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).5

CRE loan exposureIf you compare the amount of CRE loans held by the top 100 US banks with the remaining US banks, you get a relatively balanced picture. As of September 2012, US banks held US$1.5 trillion of CRE loans, with the top 100 banks holding US$766 billion, or 51%, and the remaining banks 49%, or US$734 billion. Based on both dollar amount and percentages, the two categories of banks were fairly even.

Compare the CRE loans of these two categories of banks against their 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, CRE loans made up 25% of the nearly US$3 trillion of assets of the remaining banks.

Table #1: US banks: CRE loan exposure

Banks Total assets CRE loans% of balance sheet

7,190 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 12/31/12

Composition of CRE loans: top 100 vs. remaining banksOutside the top 100 banks, the remaining 7,000 or so US banks are mainly regional and community banks. They hold construction loans, acquisition and development loans, and commercial property loans on thousands of small office buildings, retail centers, apartments and condominiums, and other commercial real estate nationwide. Individually, these are small loans, but, in aggregate, they constitute a significant part of 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-rise apartments in leading markets in the US and globally. While many banks, from global institutions to small community banks, experienced an increase in distressed CRE loans, regional and smaller banks have been especially affected because of their greater CRE exposure in relation to their asset size.


Distressed loans In December 2007, at the onset of the US recession and financial crisis, distressed loans on the balance sheets of US banks totaled just US$9.7 billion. Cumulative commercial real estate NPLs6 held by banks, CMBS investors, and others have increased ever since, reaching US$354 billion in December 2011 and US$394 billion in December 2012 (the latest month for which information is available).

Because of banks’ steady progress in resolving NPLs, their net distressed loans peaked in February 2011 at US$188 billion. Net NPLs have declined since then; however, as of December 2012, lenders still held US$164 billion of distressed loans.7

2013 bank outlook After rapid growth in 2012, US bank deposits fell sharply at the 25 largest US lenders in early January. Some market analysts said a key reason might have been the end of the FDIC’s Transaction Account Guarantee (TAG) Program, which guaranteed non-interest-bearing accounts above the FDIC’s general US$250,000 limit.8 Whether this is the start of a long-term decline in deposits remains to be seen.

In December 2012, the banks’ loan activity unexpectedly jumped as corporate borrowers hurried to close loan transactions before tax law changes took effect in 2013 as a result of the fiscal cliff.9

In early 2013, bank lending to businesses surged as large banks as well as small institutions sought to put their deposit money to work. Some banks reportedly are easing credit standards in an effort to beat competitors in originating loans, but the new business has come at a cost: a decline in loan yields and a narrowing of loan margins.10

ConsolidationConsolidation in the banking industry could be another driver of NPL sales. Invictus Consulting Group LLC said in a study that more than half of the 7,000-plus US banks should undertake merger and acquisition activity to preserve shareholder value. Banks across the country are facing increased regulatory capital requirements, declining net interest margins and increased competition, leaving many banks with no prospect of organic growth.11 If consolidation accelerates, more NPL portfolios will likely come on the market as banks clean up their balance sheets in preparation for or subsequent to mergers.

Flocking to Europe | 2013 distressed real estate investor survey

Page 25

Additions to distress

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Source: Real Captial Analytics


CMBS market reboundsThe delinquency rate of loans that underlie commercial mortgage-backed securities declined to an 11-month low in January 2013, according to researcher Trepp LLC.15 The delinquency rate fell to 9.57% in January from 9.7% in Q4 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 US issuance exceeded US$228 billion. But after almost coming to a halt in 2008, the market has made a strong comeback. Investor demand for CMBS bonds has been increasing on the strength of the recovery in the institutional quality commercial property markets.16 Indeed, based on CMBS issuances through February 2013, underwriters are on pace to issue US$100 billion in new bonds for 2013. Based on only two months’ volume, that number may not be achieved; however, it’s a comforting signal for borrowers that the CMBS market is on its way back.

Some property owners who once were shut out of credit markets recently have found that they can obtain commercial mortgage financing at relatively low interest rates and increasingly lenient terms via the CMBS market.17 How long conditions 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 should continue to recover in 2013, based on the slow but sustained growth of the US economy and improvement in property fundamentals. However, to date, that improvement has been concentrated in US gateway cities, such as New York, Los Angeles, Chicago and San Francisco. Outside these centers of commerce, commercial property values have risen only modestly at best, and some tertiary property markets continue to languish.

US economy: 2.4% growth consensus forecast for 2013The consensus forecast of economists surveyed by The Wall Street Journal in early February was that the US economy will grow at a steady but unspectacular 2.4% rate this year. In 2012, the economy grew at a 1.5% rate, the US Commerce Department reported.12 Unemployment is forecast to drop to 7.4% from 7.8% in 2012.

Vacancy rate expected to decline In its November 2012 quarterly commercial real estate forecast, the National Association of Realtors said commercial property vacancy rates are expected to decline in 2013.13 The office sector should continue to have the highest vacancy rate and multifamily the lowest.

Table #2: Commercial real estate vacancy forecast

Sector Q4 2012 Q4 2013

Office 16.7% 15.7%

Industrial 10.1% 9.5%

Retail 10.8% 10.6%

Multifamily 4.0% 3.9%Source: National Association of Realtors

In another positive sign, Green Street Advisors reported that institutional quality commercial property values moved steadily higher in 2012. As of early January, some property sectors in key national markets were close to their 2007 highs.14


Maturing CMBS loansWhile CMBS new loan originations are improving, two issues continue to loom over the market. One is the persistence of delinquencies on CMBS legacy loans. The other is a sharp increase in maturing CMBS loans that will begin in 2015. Until then, the CMBS loan market will remain relatively stable. More than US$50 billion in CMBS loans will mature this year and about the same amount in 2014. In 2015, however, maturing loans will jump to US$97 billion and, in 2016 and 2017, to more than US$130 billion. In 2018, they will drop to US$7 billion.18

The spike in maturing loans over the next few years is significant because some borrowers will not be able to pay off or refinance their loans and will be at risk of default. Some of these loans were written in 2007 at the height of a commercial property boom, and borrowers were able to finance 80% or more of property values. Today, lenders are financing or refinancing mortgages at lower percentages of property values, thus requiring property owners and developers to invest more equity in their properties. By one estimate, the equity shortfall will equal about US$100 billion annually for the next three to four years.19 That is equity some borrowers may not have, and unless they are able to negotiate loan extensions or refinancings with lenders, they could be at risk of defaulting — and lenders could be at risk of adding more NPLs to their portfolios.

2013 NPL sales outlookBanks began stepping up their NPL sales in 2009, and sales activity has continued to increase. Information about sales figures is hard to come by, but it’s estimated that banks’ sales of non-performing CRE loans totaled at least US$15 billion in 2012, down from approximately US$26 billion in 2011.

While many banks and CMBS special servicers have been active sellers of NPLs, some have foregone sales. Part of the reason may be that they have been waiting for the US economy to recover more fully and property markets to rebound. Also, they may not have been willing to sell loans at the discounts necessary to attract investors. Even if they were to sell, banks do not want to incur losses that would reduce their profits and erode their capital, and special servicers do not want to reduce distributions to CMBS investors.

More reason to sell in 2013?Those banks and CMBS special servicers that so far have refrained from selling NPLs may have more reason to do so in 2013. If the US economy continues its slow-but-steady growth and the US unemployment rate continues to decline, there might be a modest increase in demand for space in commercial properties this year. Commercial property values are recovering, and vacancy rates are declining, although vacancies remain at high levels except for multifamily properties. “U.S. banks holding large levels of non-performing assets (NPAs) on their balance sheets are likely to pursue more bulk sales of distressed loans this year and next,” according to Fitch Ratings.20 It said that if market liquidity and asset pricing continue to improve in 2013, many smaller institutions with large residual NPA balances will be better positioned to use bulk sales to strengthen balance sheets.

Donald Sheets is a senior principal in the New York office of Square Mile Capital Management (SMCM), a real estate private equity fund with US$1.9 billion in assets under management (AUM).

At SMCM, Sheets structures and negotiates nontraditional commercial real estate investment opportunities, including distressed debt, discounted performing commercial mortgages, preferred equity, mezzanine financing and real estate enterprise liquidations. He has more than 13 years of property acquisition, turnaround, asset management and restructuring experience across a variety of capital structures, asset types and geographies.

Sheets is an adjunct assistant professor of real estate development in Columbia University’s Graduate School of Architecture, Planning and Preservation.

Could you provide an overview of SMCM? We’re an opportunity fund focused on special situations investing. As a 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 the financing front. We’ve created unique structures, for example, with respect to the securitization of pools of performing and non-performing debt. In 2012, we brought to market one of the first liquidating trusts that had been done in years, and we completed another one at year-end.

On the acquisition side, is SMCM primarily focused on commercial mortgage loans — performing, subperforming, non-performing? Yes, but we have a mandate for other business as well. We’re active in providing capital for consensual recapitalizations alongside capable but over-levered borrowers to effectuate DPOs (discounted payoffs) with existing lenders. In these situations, we effectively are recapitalizing the equity side rather than the debt side. We also are actively originating new mezzanine financing via a separate account that we manage on behalf of a large insurance company’s real estate subsidiary.

What returns are you looking for? About three-fourths of the loans we buy are performing and subperforming, and the remainder are NPLs. Our return criteria are different than those of a buyer that invests mostly in NPLs or those investors with a predicated “loan to own” strategy. We generally look for returns in the low to mid teens on unlevered transactions, and levered returns in the mid to upper teens.

Do you have a sense of what the volume of US NPL sales was in 2012? I would say around US$40 billion, which would include performing and subperforming loans as well. In 2011, there may have been around US$50 billion in sales. But it’s a difficult number to pinpoint.

What’s the outlook for US NPL sales in 2013? From our view of the debt pipeline, 2012 had less volume than 2011. But 2011 sales were magnified by the Anglo Irish, Bank of Ireland and Allied Irish Bank sales of their commercial real estate loan portfolios. If you strip Irish portfolio sales away, then 2012 was about as busy as 2011. As for 2013, I look for it to be about as active as 2012.

Who will be selling this year? The caliber of sellers is transitioning a bit. The FDIC clearly is not as active as it was. It may do a structured sale or two specifically aimed at smaller investors or it will securitize small balance claims. The agency completed a couple of securitizations in 2011 and 2012. I wouldn’t be surprised if it uses that mechanism going forward versus the structured sale format. I don’t see them as that active of a contributor in 2013, primarily because the number of failing banks is decelerating.

What about special servicers? Special servicers for NPLs certainly will remain active, and that activity should increase in 2013. Unfortunately, those sales of claims probably will be through the online auction process, which most institutional investors 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 million and US$10 million — tend to be placed into an online auction site. It’s distorting in terms of knowing what’s actually trading and at what price levels.

Interview with Donald Sheets, Square Mile Capital Management


And there will also be negotiated sales by banks in 2013? Yes, there will be negotiated transactions through traditional channels. Market participants also are talking about loss-share agreements maturing.21 Beginning probably in the second half of 2013, and continuing through 2016, buyers of failed banks acquired from the FDIC under loss-share agreements will resolve or liquidate in bulk non-performing assets. Any assets that the banks aren’t able to resolve before the end of their five-year window 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 over the next few years in sales driven by these loss-share agreements.

Who else will be selling NPLs in 2013? Other sellers will include well-capitalized money center banks that have extended or modified loans on at least one or more occasions. They will look for liquidity by selling loans, which generally will be subperforming loans rather than non-performing. These loans may be a bit over-levered and likely have been previously restructured. These banks have sufficiently marked down most of their loan books and now have the earnings to absorb losses from selling them. In addition, some European banks that still hold portfolios of US commercial mortgages might continue to bring these portfolios to market in 2013.

How are buyers financing deals? Leverage terms have continued to evolve. I would say that there are five or six credible 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 and the coupon has decreased. That makes the cost of capital more efficient to bridge the bid/ask spread in the marketplace.

There have been just a few big transactions by US banks and foreign banks, but we really haven’t seen many sizable transactions. Is that what you’re seeing? We expect continued portfolio sales in 2013. But I also believe that we’ll see one-off sales of large single loans backed by multiple assets. Examples will include a credit facility secured by seven or eight assets, or a single loan to a company that is secured by the company’s assets, which might include real estate. Some

portfolios of participations also could come to market this year. Sellers will include banks that are in various credits but do not have full control rights and are looking for liquidity or are winding 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 transparent process, so we see product coming through the advisory channel. But that doesn’t necessarily mean a lot of qualified bidders show up. Only two or three credible bids may be made that can close. So there are auctions — either broad auctions or limited auctions. Then there are the bespoke transactions that usually are one-off. Over the years, I’ve built relationships with several banks, and if they have something to trade quietly and swiftly, usually in the form of a one-off credit or two, we can usually do a direct negotiation with the seller.

Any preferences on loan type and deal size? We’re agnostic on geography, asset class and loan performance status. We typically invest at least US$15 million in a single transaction, and we have acquired portfolios in excess of US$600 million in outstanding principal balance.

Do you see opportunities in Europe? We presently are exploring opportunities in Europe, which is in the early stages of NPL portfolio sales. To use a baseball analogy, the fans are just taking their seats. Once there’s a mandate from the European Central Bank for banks to start winding down their NPL portfolios, there will be more product coming out of banks, but I don’t know what they will look like since we are just beginning to investigate the marketplace. Which loans will come out of banks first? Better quality? Worse quality? Small balance? It remains fluid.

How does that baseball analogy apply to the US NPL market? I would say the US NPL market is in the fourth or fifth inning in terms of sales activity. Some people are moving away from buying mortgages and instead are migrating toward acquiring properties directly. Therefore, the market for secondary commercial mortgage debt is a little less crowded today, which makes us happy.

Flocking to Europe Ernst & Young 2013 real estate non-performing loan report 10


Europe’s market for non-performing loans is growing. Estimates vary, 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 and Real Estate Investments at Cerberus Capital Management. (An interview with Millstein appears on page 15.)

The opportunities in Europe have commanded the attention of global investors. “Europe will attract more investment from investors worldwide, and the pipeline will grow over the next few years,” said David Abrams. He is Senior Portfolio Manager of Non-performing Loans at Apollo Management International and Managing Partner and Co-Founder of Apollo European Principal Finance Fund. (An interview with Abrams appears on page 23.)

Investor interest isn’t limited to non-performing real estate loans. European real estate generally is attracting more investment, particularly from US investors.22 In December 2012, the German Government agreed to sell TLG Immobilien, a company that owns stores, offices, warehouses and hotels in the country’s eastern states, to Lone Star Funds for €1.1 billion, including debt.23

Compared with a year ago, investors today see the Eurozone’s future as more secure. Central Bank policies have reduced the immediate risk of a Eurozone breakup, while progress has been made toward a banking union that would put the euro on a stronger long-term footing.24

SaleandrefinancingtargetsMorgan Stanley estimates that Europe’s banks need to sell or refinance €700 billion of NPLs to meet regulatory capital requirements, deleverage their balance sheets and achieve other goals. As of January 2013, banks had sold or refinanced NPLs equal to 20% to 25% of that target.25

Since the financial crisis, about half of the reductions to banks’ loan books has come from borrowers repaying debts, according to Morgan Stanley. Roughly 20% has come from debt sales, and another 25% has come from writing down debt. The balance has come from asset repossessions, primarily in Spain.

Until now, the leading international buyers of Europe’s distressed loans have been US-based private equity firms. Such is the demand for NPLs, however, that other investors have entered the market, including smaller private equity firms, sovereign wealth funds, wealthy individuals, family offices and US real estate investment trusts (REITs). In some cases, these investors have offered higher prices than the big firms. Some banks are starting to sell individual assets or small portfolios to these investors while continuing to do large portfolio transactions with the biggest investors.26

EuropeMore investor interestAt an Ernst & Young real estate workshop held in January 2013 in London, we surveyed workshop participants on the outlook for real estate NPL investment in Europe this year.27 About three-fourths of those responding to the workshop survey said they expect deal flow to increase in 2013. As for their own plans, about 85% said they are in a “buying mode.” Among European countries, the UK will be the most active market for investment, according to two-thirds of respondents: about 22% said Spain and 11% Ireland.

Another sign of interest in Europe’s NPL market comes from the survey of real estate NPL investors for this report. (Nearly a third of the survey respondents are based in Europe and the rest in the US.) Of all of the respondents, a third said Europe will be their primary focus for NPLs over the next 12 months. The respondents focused on Europe are primarily interested in investment opportunities in Germany, the United Kingdom, Ireland and Spain. (See responses to Question 5 of the survey on page 25 of this report.) More than half of the respondents said the European market will remain active for the next 36 to 48 months.

European banks: more exposure to commercial property lendingNPLs secured by commercial real estate are a primary target of investors, because European banks are prominent commercial property lenders, among other reasons. In Europe, about three-fourths of outstanding commercial mortgage debt is held by banks versus CMBS or insurance companies or other institutions. By comparison, in the US, banks account for about 55% of commercial mortgage debt.28 Furthermore, Europe’s CMBS market is relatively small compared with the US market because European banks generally keep loans on their balance sheets rather than securitizing them, so European banks have more exposure to the risks of commercial real estate lending — including the risk of some performing property loans becoming non-performing. Moody’s said in a January 2013 report that many European banks, particularly those in Spain, Italy, Ireland and the UK, require material amounts of additional provisions to fully clean up their balance sheets.29 It did not say how much money would be needed.


Table #3: European banking snapshot30

2012 2013* 2014*

Total assets (€bn) 33,631 33,200 33,928

Total loans (€bn) 12,264 12,132 12,487

Business and corporate loans (€bn)

4,619 4,628 4,821

Consumer credit (€bn) 604 597 606

Residential mortgage loans (€bn) 3,791 3,767 3,827

NPLs as % of total gross loans 6.8 7.6 5.6

Deposits (% year) 0.9 3.2 4.1

Loans/deposits (% increase from prior year)

111 106 105

Total operating income (€bn) 632 651 706*Source: Ernst & Young Eurozone Forecast

NPLs expected to peak in 2013In the Eurozone, total NPLs (including real estate) as a percentage of banks’ total loans increased from 5.6% in 2011 to 6.8% in 2012. This year, the Eurozone’s economy is expected to contract slightly, and, based on Oxford Economics research, NPLs will reach a euro-era high of €932 billion, amounting to 7.6% of total loans of €12.2 trillion, according to an Ernst & Young report.31 As economic conditions improve in 2014, NPLs are expected to drop to 5.6% of €12.5 trillion of outstanding loans, or the same percentage as in 2011. However, the Eurozone’s growth is expected to be modest, averaging about 1.3% annually for the rest of this decade.32

To sell or not to sellThe expected increase in NPLs in 2013, as well as regulatory requirements and banks’ increased focus on profitability, could motivate banks to unload more of their bad loans. In addition, banks will continue to focus on strengthening their balance sheets and cutting costs in 2013,33 and they will try to sell NPLs as part of the process of deleveraging and improving their financial position. Finally, as we noted in a 2011 report on Europe’s NPL market, some banks are changing to a stronger, more sustainable and more competitive business model, one that balances the need for profit against an appropriate level of risk.34 This gives them another reason to sell NPLs.

Alternatives to sellingAs an alternative to selling NPLs, banks could restructure some of their loans — and some banks have done so. But the restructuring process is often complicated, ties up bank resources and is time consuming. Selling can offer a more efficient, faster solution. As another alternative to selling, banks have shored up balance sheets and increased capital reserves, for example, by issuing shares or converting lower-quality capital to common equity.35 But that still leaves them with the problem of what to do with their NPLs.

The bad bank option One solution currently in favor by some countries is to establish a government-sponsored bad bank, where the troubled financial institutions contribute their NPLs and other troubled loans to the bad bank, thus cleansing their balance sheet of these loans and freeing the bank from the distraction, costs and use of resources inherent in managing a portfolio of troubled loans. Of course, this strategy does little to reduce the overall exposure to NPLs at the country level, since they still exist in the system, albeit not at the banking level. Nevertheless, the strategy has merit. Rather than individual banks implementing many different strategies to resolve their NPL problems, the bad bank can plan and execute an orderly disposition of the NPLs received from multiple banks, whether at auction or through direct negotiations or other strategy.

Holding NPLsAgainst the reasons to sell, banks also have reasons to keep NPLs on their balance sheets. In selling, banks would likely have to recognize losses that would reduce their capital and cut their profits. Undercapitalized banks with thin profit margins might not be able to absorb such losses.

The European Central Bank’s (ECB) program to provide cheap financing to some of the region’s largest banks has reduced the pressure on these banks to sell bad loans. While the ECB’s moves were designed to prevent a credit crisis and further weakening of the European economy, market analysts are concerned that banks will leave capital tied up in non-performing loans and assets in a process known as “pretend and extend.” This could leave some banks unable to provide enough credit to meet the ordinary needs of companies, businesses and other borrowers.36

In January 2013, the Basel Committee on banking supervision confirmed that it had given lenders four more years to put in place the new liquidity coverage ratio (LCR). In 2015, banks must have only 60% of the LCR in place instead of the original 100%. They will have four more years, or until 2019, to meet the 100% requirement.37 The purpose of the rule change is to


ensure that banks have enough liquid assets to meet a short-term market crisis. It could also give banks more time to work out, restructure or sell their NPLs rather than taking more immediate action.

Pricing issuesPricing issues are keeping some banks from selling NPLs. Banks, of course, try to secure the highest possible prices in order to maximize their recovery and minimize their losses from NPL sales. But some investors say banks have overpriced assets given the current weakness in Europe’s economy, the general level of commercial property values, and the risks and costs to investors in performing due diligence and repositioning the underlying collateral for restructuring and future sale. Another challenge for investors lies in dealing with different legal systems in countries where they invest. Nevertheless, deals are getting done, but with a wide range in pricing. In the UK and Ireland, NPLs sold last year for 20% to as much as 90% below outstanding claim amount.

NPL sales activity picking upSo far, some of the largest sales of distressed loans have been by banks in the UK and Ireland. Among other reasons, investors have focused on these countries because of the relative ease in getting to the underlying collateral, unlike some other countries where, for example, foreclosures take a longer time period to complete.38

This year, NPL sales activity is picking up as European banks focus on deleveraging their balance sheets. In addition to selling portfolios of NPLs only, some banks are retrenching and selling so-called non-core portfolios consisting of a mix of performing, subperforming and non-performing loans collateralized by properties that typically are in regions outside the bank’s core operating geography. Banks also are selling loans on single properties, which could help to attract investors that might not bid on large portfolios.

NPL marketsGermanyGermany developed into a mature NPL market during the 2003 to 2007 period, before the global recession and financial crisis hit. Today, it has the necessary legal framework and advisor and servicer network to attract international investors and support a high volume of NPL transactions. However, while a small number of larger NPL transactions were completed during the past two years, overall market activity has so far remained unexpectedly low considering the amount of NPLs on the books of Germany’s

banks. At the end of 2012, German banks held an estimated €200 billion of NPLs. This year, because of increased NPL sales activity and an improving Eurozone economy, the banks’ NPLs are expected to decline to €183 billion in 2013, according to the 2012–13 winter edition of the Ernst & Young Eurozone Forecast.39 But that would still leave a significant amount of NPLs weighing down the German banking system.

Banks have been reluctant to sell NPLs partly because of the uncertainty created by the global financial crisis and Eurozone crisis of recent years. Furthermore, almost all German private banks and Landesbanken have been forced to deleverage and shrink their balance sheets to reach or maintain Basel III core capital ratios. In the course of deleveraging, banks have so far held on to their NPLs until investor pricing is more in line with bank carrying values.

While banks have refrained from selling NPLs, they have been working on improving their core capital ratios, gradually adjusting their loan book values to reflect investor pricing, and restoring or maintaining profitability. Most banks have set up internal restructuring units to work out or sell NPLs as well as dispose of non-core parts of their businesses. In addition, two German bad banks have been incorporated (FMS Wertmanagement and EAA). They hold assets transferred from Hypo Real Estate (FMS) and WestLB (EAA) to resolve large pools of non-core and non-performing assets over a 15- to 20-year period. Their strategy so far has been more focused on resolution solutions other than sales, although the bad banks are 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 sale of NPLs. The support of the European Central Bank for the Eurozone has calmed financial markets. Most banks are in the process of completing strategic realignments, while using the cheap liquidity provided by the central bank to improve profitability and core capital ratios. The value of the real estate collateralizing NPLs is increasing on the overall strength of German property markets. Germany is attracting more property investment from international and domestic investors seeking higher yields and a safe haven. The gap between NPL bid and ask prices could narrow if the strength of German banks and property markets gives investors confidence to pay higher prices for NPL portfolios.

In February 2013, Lloyds Bank of the UK sold the first sizable portfolio of non-performing loans secured by German retail real estate collateral. This transaction, with a face value of €850 million, drew a number of global investors who competed to secure the deal. While too soon to tell, this deal may come to be the icebreaker transaction that will motivate a large number of German banks to test the market for NPL sales.


UK and IrelandIn 2011, an NPL market began to take shape in the UK and Ireland. While there has not been the wave of transactions that some market analysts anticipated, nine transactions totaling more than €8 billion were completed between July 2011 and September 2012,40 and more have been completed since then.

In January 2013, Fitch Ratings said in a report that major UK banks are generally soundly capitalized, but they need to continue deleveraging and restructuring to meet Basel III targets. It took note of banks’ risk exposure to soured commercial real estate loans, saying many may need to be renegotiated or sold in the near future.41

Ireland’s property markets are showing signs of recovering. Property prices are expected to bottom out in 2013. Ireland’s state-owned banks reportedly are speeding up the sale of tens of billions of euros’ worth of property-backed loans.42 In a move to help prop up the banking industry and to facilitate the orderly disposition of troubled loans, Ireland created a bad bank known as the National Asset Management Agency (NAMA) in 2009. The agency has acquired €74 billion of loans from participating financial institutions. As of year-end 2012 it had disposed of €6.9 billion in assets.43

In early February 2013, the European Central Bank cleared a plan for Ireland to liquidate the former Anglo Irish Bank now known as IBRC. Under the plan, the debt taken on by the Irish Government to finance Anglo Irish’s rescue will be swapped for long-term government bonds.44 The government initiated the liquidation to reduce the burden of €31b in promissory notes, a form of an “IOU” given to IBRC to allow it to borrow from the Central Bank of Ireland.45

Domestic as well as international banks are selling real estate loan portfolios, including portfolios of distressed property loans. In November 2012, Apollo Global Management reportedly paid £149 million to buy a portfolio of distressed commercial property loans in Ireland from Lloyds Banking Group. Lloyds has taken an aggressive approach to unwinding a reported £24 billion of non-performing property loans; in the first nine months of 2012 it reduced its real estate exposure by a reported £4.1 billion.46

SpainWhile currently not attracting as much interest from NPL investors as other countries, Spain could become one of the most active NPL markets. With Spain’s economy expected to remain in recession throughout 2013, it is likely that NPLs will continue to climb.47 Today, Spain has one of the largest exposures to NPLs, with about €190 billion in troubled loans.

Yet transactions have been limited. However, recent regulatory reforms have had the effect of enabling NPL transactions at lower prices, and bid and ask spreads are narrowing, helping to enable sales. Also helping sales are deal structures in which banks share the risks with buyers in resolving the loans, such as through workouts and restructures.

Spain’s Government has created SAREB, a bad bank designed to acquire NPLs from the country’s banks. With SAREB in the start-up stage, it’s too early to know its impact on the country’s NPL problem. But expectations are high, and opportunities for investors will likely follow. SAREB has begun the process of buying up to €90 billion of NPLs and other assets from banks. SAREB plans to sell the assets to investors over a long-term period.

Lee Millstein is Head of European and Asian Distressed and Real Estate Investments and Senior Managing Director of Cerberus Capital Management.

In an interview, Millstein discussed opportunities to invest in NPLs in Europe, the investment outlook in Europe and how the European NPL market compares with the US market.

How do opportunities to invest in NPLs in Europe compare with the rest of the world? Right now, Europe represents the biggest NPL opportunity worldwide. In my view, European NPLs are one of the best investment opportunities of any asset class globally.

Why? That assessment is based on the significant size of Europe’s banking system compared with the European economy, the shortage of capital in the banking system, the size of the NPL market, the state of the European economy and other criteria.

What’s the size of the European NPL market? Between €3 trillion and €3.5 trillion of total non-core assets, including over €1 trillion of NPLs. If you assume these numbers, and compare it with NPL sales to date, sales activity has been moderate. But there are numerous signs that it is picking up rapidly.

How did you arrive at the more than €1 trillion figure? It’s derived from a country-by-country analysis of the NPL market. It’s based on information that’s publicly available, talking with people in the market, our long experience in this market and other sources. If anything, that estimate might be understated.

What’s this year’s outlook for NPL sales in Europe? Sales in 2012 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 the pipeline, deals under discussion, deals that have already been awarded in the first few weeks of 2013, in-depth discussions directly with selling banks, as well as advisors and others. Like any great opportunity, the European NPL pipeline isn’t growing as big as investors likely prefer today, but it is moving in the right direction. Banks and regulators realize that NPL deals are the only solutions that work for everyone.

Are you focused on investment opportunities in particular countries in Europe? There are five countries where we are examining opportunities very closely: Germany, UK, Ireland, Spain and Italy. Our primary focus has been on the UK and Germany, and will likely remain so for the next 12 months, based on the deals we’ve done, our deal pipeline and where we see the best opportunities. But activity in Spain and Ireland is growing rapidly.

In Europe’s commercial real estate sector, what types of loans are you interested in? We look at everything. We invest in a wide range of loans, including residential, consumer, corporate, commercial and industrial, secured, unsecured and others. We will consider investing in smaller loan portfolios as well as in the largest.

How about deal size? We look at the entire range. We’ve looked at deals as small as US$25 million to US$50 million. We’ve also done a number of deals between US$300 million to US$500 million, and some above US$500 million.

What pressure is there on European banks from governments and the market to move NPLs off their books? The pressure in Europe is coming from several fronts. First, banks will have to gradually meet the new Basel III minimum international capital requirements, which make it very capital intensive to hold NPLs. Second, it’s costly for banks to keep NPLs on their balance sheets. NPLs generate zero income, and the banks typically don’t have experienced workout platforms. So it’s better for the 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 the best holders and servicers of NPLs. A good example of that is what happened in Asia in the 1990s. The European banks have learned that lesson and understand moving first and fast is to their benefit.

Why Asia? In Asia, Japanese banks held their NPLs for a very long time, and when they finally did sell, it was at deeply discounted prices. Korean banks moved NPLs off their books more quickly, and at far better prices.

Interview with Lee Millstein, Cerberus Capital Management


Flocking to Europe Ernst & Young 2013 real estate non-performing loan report

Irish banks and some other European banks have been selling foreign assets, including NPLs and other non-core assets. Do you expect this trend to continue? A lot of banks are retrenching to their home markets. They want to concentrate on addressing NPL problems in non-core markets. It’s a continuing trend.

What returns do you anticipate from your investments in Europe? It’s too early to say what they will be. We’ve had the same 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 investment opportunities in Europe? Compared with the Asian NPL market of the past, Europe’s NPL problem today is probably twice the size of Asia’s. In Asia, there was a steady flow of NPLs for six straight years. In Europe, I would expect the deal flow to continue for another three to five years.

Are there any opportunities for small US investors to get into the European NPL market? This is not an investment for small US investors. There are two ways to do deals: at auctions or in negotiated deals. On the auction front, most investors are maintaining discipline. If more than three or four investors are invited, most investors have the good judgment not to participate.

How about on the negotiated deal side? As for negotiated deals, banks want investors that they know, with a track record of creative solutions to NPL problems, that have the capital, and can help manage the assets and maintain confidentiality. What all this means for small US investors is that it is very difficult to break into the European market in competition with firms like ours that have been in the NPL market for a long time and have large dedicated teams to underwrite, acquire and service the NPLs. It’s hard for any new entrant to build relationships with banks 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.

Interview with Lee Millstein, Cerberus Capital Management

16


OverviewInvestment activitySurvey respondents expect the US NPL market to remain active, but for a shorter time period than they did a year ago. More respondents to this year’s report said they expect the market to remain active for 12 to 18 months; a year ago, many respondents thought it would stay active for 24 to 36 months. As in past surveys, investors said their first choice for accessing the market is through off-market transactions or direct negotiations.

About a third of investors said they have shifted their primary focus to Europe, which is emerging as the world’s largest market for distressed loans. Investors targeting Europe are primarily interested in NPL investment opportunities in Germany, the UK, Ireland and Spain. More than half of them expect the European market to remain active for 36 to 48 months.

Capital allocationMore investors said they have allocated less than US$100 million for investment in NPLs this year. This may be because they expect to invest less in NPLs in 2013, and they are directing their investments more toward buying smaller portfolios from regional or local banks. Investor allocations of more than US$100 million to more than US$1 billion are about the 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 than US$100 million of capital in NPLs this year may prefer deals in this range to transactions of less than US$50 million. Fewer investors are seeking deals in the US$100 million–US$500 million range, perhaps because not as many investors have the capital to buy NPLs in this range, or there simply were fewer deal opportunities. About 8% of respondents, presumably including the biggest NPL investors, are looking for deals of US$1 billion or more.

LeverageInvestors appear to be putting more equity into transactions. All-cash buyers increased in our latest survey, and the percentage of investors using less than 50% leverage increased while those using more than 50% declined.

Investment returnsInvestors appear to have lowered their return expectations somewhat, possibly because values of the properties underlying NPLs have been improving along with a general recovery in commercial property prices, and NPL yields are declining. More investors are seeking 10%–15% returns, and fewer are looking for returns of 20% or more. Those targeting 15%–20% returns remained about the same as a year ago.

Survey findings


Survey findings: the details

1. Investment activityThe survey asked respondents how “active” they were, meaning the time, effort and resources they are putting into seeking opportunities to acquire distressed loans. In 2010, only 5% of survey respondents said they were less active than a year ago. That figure has increased every year since then. In 2013, it reached 30% for the first time. Correspondingly, there has been a decrease in respondents who were more active, from 49% in 2010 to about 32% in 2012. Respondents who said their investment activity was about the same as a year ago declined to about 38% in 2012. In previous surveys, it was 46%.

Question1:WhatisyourNPLportfolio-activitylevelcomparedwith12monthsago?

2013 compared to 12 months ago




Same 38% 46% 46% 46%

More 32% 26% 35% 49%

Less 30% 28% 19% 5%

Source: Ernst & Young LLP

troubleshooting, 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,


2. Capital allocationAbout a third of survey respondents have allocated less than US$100 million for the purchase of NPL portfolios in 2013, up from 23% in last year’s survey. In other categories, planned allocations are about the same as a year ago. More investors are specific about their plans this year: only 23% said they haven’t allocated a specific amount for investment in 2013. Last year, nearly a third hadn’t decided on an allocation amount.

Question2:HowmuchcapitalhasyourcompanyallocatedforthepurchaseofNPL portfolios in 2013?

2013 2012 2011 2010

None — 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% —


3. Method of buying loan portfoliosAs in 2012, respondents most often are accessing the NPLs market through off-market transactions and direct negotiations, followed by broadly marketed offerings by sales agents (sealed bid auctions). Respondents were least likely to use online auctions, which was also true in previous surveys. Some respondents said they used other means to access the market, such as loan servicers, investment bankers or direct negotiations with owners.

Question3:HowareyouaccessingthemarketforNPLs? (Please rank from 1 to 4, with 1 being the most frequent.)

2013 2012

Using online resources such as internet auction sites 2.84 3.18

Off market transaction sources and direct negotiations 1.41 1.56

Participating in broadly marketed offerings by sales agents (multiple bid) 2.33 2.22

Other 3.42 3.08


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4. Europe draws interest; US remains primary marketWith the growing investor interest in Europe’s NPL market, we added questions about Europe in our current report. About 30% of respondents said Europe will be their primary focus in 2013, and some said the UK specifically. About two-thirds of respondents said they will focus on the US. A few said Asia.

Question4:Foryourcompany,whatmarketistheprimaryfocusforNPLsoverthe next 12 months?

US Europe Asia Americas non US

65.6% 31.1% 3.3% 0.0%


5. European investors target Germany, UK, Ireland and SpainOf the investors primarily focused on Europe this year, nearly half said Germany was their target market, more than a third said the UK, about 33% said Spain and 30% Ireland.

Question5:InwhichcountriesinEuropeisyourcompanyfocusedonpurchasingNPLsover the coming 12 months? (Choose all that apply.)

Countryover the coming 12 months

Czech 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) —



6. Deal sizeSince we began our survey, the biggest change in deal size has been in the percentage of investors seeking deals of US$50 million or less. At 60% in our 2010 survey, that percentage declined to 35% in our latest survey. Investors seeking deals of US$50 million–US$100 million increased in our latest survey to 23% from 20% a year earlier. Investors interested in deals of US$100 million–US$500 million declined to 16% from 20% a year ago. Those seeking deals of more than US$500 million increased to 8% from 4%. A slightly lower percentage of respondents are unsure about the deal size they want.

Question6:Whatdealsizeareyouinterestedin?

2013 2012 2011 2010

$500 million or more 8% 4% 3% —



Less than $50 million 35% 36% 43% 60%

Not sure or depends 18% 20% — —

No plans to invest in NPL portfolios — — 16% —


7. 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 came in the percentage of respondents seeking returns of 10%–15%. That percentage increased to 29% in our latest survey from 20% a year ago.

Question7:Whatareyourinvestmentreturnrequirements (unleveraged internal rate of return)?

Investment return requirements 2013 2012 2011 2010

below 10% — 3% — 2%

10% — 15% 29% 20% 30% 40%

16% — 20% 49% 52% 62% 42%

above 20% 22% 25% 8% 16%



8. Leverage requirementsAbout 63% of respondents said they use some leverage, compared with about 67% year ago. But investors appear to be using less leverage. Some 25% of investors said their leverage requirement is 51%–60%, down from 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.

Question8:Whatisyourleverageexpectationorrequirement?

Leverage 2013 2012

0% — 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%


9. US NPL market outlookRespondents to this year’s survey shortened their time frame for how long they think the US NPL market will remain active. About 20% expect it to remain active for up to 18 months vs. 4% a year earlier. Only about 13% expect it to remain active for up to 36 months vs. 29% a year earlier. Only 5% see it staying active for 48 months.

Question9:Howlongdoyouthink the US NPL market will be active?

2013 2012

No longer active 3% —

Next 12 months 14% 4%





No opinion 23% —


10. European NPL market outlookBased on responses to this year’s survey, investors think the European NPL market will stay active longer than the US NPL market. More than half the respondents said the European market will stay active for 36 to 48 months. Only about 8% said it will remain active for up to 24 months. The rest had no opinion.

Question10:Howlongdoyou think the European NPL market will remain active?

2013

Next 12 months 0%

Next 18 months 4%

Next 24 months 8%

Next 36 months 22%

Next 48 months 33%

No opinion 33%


In a recent interview, David Abrams and Steve McElwain of Apollo Management International, LLP, discussed the outlook for distressed debt markets in Europe. Based in London, Abrams is Senior Portfolio Manager of Non-performing Loans at Apollo Management International and Managing Partner and Co-Founder of Apollo European Principal Finance Fund. McElwain is a Principal with Apollo European Principal Finance Fund.

What’s your assessment of the size of Europe’s distressed debt market? We estimate it’s about €1.5 trillion – about €750 billion of NPLs and €750 billion of performing and non-performing, core and non-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 to us as a very large problem with respect to distressed loans. Very few of these problem loans have been sold, and we believe banks will be selling loans 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 investors worldwide, and the pipeline is expected to continue to grow over the next few years. The forced liquidation of assets by bailed-out banks should continue. Banks are trying to manage new capital requirements and address liquidity issues, and they are seeking creative solutions to their problematic distressed loans. We believe this dynamic should result in fewer auctions and more direct negotiations for the sale of loan portfolios.

Will banks be selling assets other than distressed loans? From our perspective, yes —we believe sales will not be limited to only distressed loans. We are seeing banks and other financial institutions, not just in Europe but elsewhere around the world, looking for ways to exit from asset classes that no longer fit within their core areas of focus.

How much capital has Apollo raised for investment in European NPLs? We raised approximately €1.3 billion for our first fund, which is almost fully invested. We recently held the final fundraising for our second fund, Apollo European Principal Finance Fund II, or EPF II, which raised about €2.5 billion. We are actively evaluating opportunities throughout Europe to identify opportunities to deploy the capital raised in EPF II.

Where are you investing in Europe? Although we target investments across Europe, we have focused on four markets: Germany, the UK, Spain and Ireland. We seek to deploy our funds’ capital with the aim of optimizing the outcome of the investments that are made — and we take an active role once our funds invest in an asset. The funds we manage typically own the servicers in each market in which we’re active, and we believe that banks appreciate the fact that we conduct our own servicing. In many cases, we have found that the banks and other financial institutions we are engaged in dialogue with are looking to redeploy their internal resources and would prefer to avoid having to deal directly with managing bad loans.

In addition to NPLs, are you buying performing assets? Over the past two years, we believe Apollo has been one of the largest investors in performing consumer debt in Europe.

We continue to evaluate other performing asset classes, but in most cases the pricing hasn’t met our return requirements. One of the most significant variables is leverage. In the current environment, many investors are taking advantage of low rates to obtain financing and invest in deals. And some investors, rather than investing equity, are entering the market and providing financing for deals.

Are you buying through the auction process as well as direct negotiations? Some deals are widely marketed through auctions, but in these types of situations valuations can be driven up, and we more often than not get priced out of a deal. We generally prefer direct negotiations with banks and other financial institutions, where we believe we can provide a quick and holistic solution to the seller.

Have you done any joint ventures? Yes — we have participated in some joint venture transactions, and, generally speaking, they have been successful. We have found that in certain situations, while banks may prefer 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 they are comfortable to share in the risks of servicing the loan portfolio and seeking 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, we continue to look for opportunities to expand our footprint in performing consumer receivables. In addition, today there are opportunities in alternatives such as rolling stock and shipping in specific markets. Regardless of the asset, our decision to invest the funds we manage depends 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 International


Appendix: comprehensive summary of survey questions and responses

24


Survey questions and responses

Same38.1%

Less30.2%

More31.7%

What is your NPL portfolio-activity level compared with 12 months ago?

Less than $100 million

32.8%

$500 million to less than

$1 billion7.8%

$100 to less than $500 million

21.9%

How much capital has your company allocated for the purchase of NPL portfolios in 2013?

None - no plans to invest in NPL

portfolios.9.4%

$1 billion or more4.7%

Do plan to invest in NPL

portfolios, but no specific amount

allocated23.4%

How are you accessing the market for NPLs?(Please rank from 1 to 4, with 1 being the most frequent.)

Using onlineresources such

as internetauction sites

2.84

Off-market transaction

sourcesand direct

negotiations1.41

Participatingin broadlymarketed

offerings bysales agents(multiple bid)

2.33

Other3.42

$500 millionor more

8.1%

Less than$50 million

35.5%

Not sure or depends

17.7% $100 millionto less than

$500 million16.1%

$50 millionto less than

$100 million22.6%

What deal size are you particularly interested in? (Select one.)

For your company, what market is the primary focus for NPLs over the next 12 months?

Americas non-US0.0%

Europe31.1%

Asia3.3%

US65.6%

For your company, what market is the primary focus for NPLs over the next 12 months? (Choose all that appy.)

Not interested in European NPLs

40.7%

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 LLP




no longer active —it has run its course

3.1%

for the next 18 months

20.3%

For the next12 months

14.1%No opinion23.4%

How long do you think the US NPL market will be active?

For the next 24 months

21.9%

For the next48 months

4.7%


12.5%


21.9%For the next 48 months

32.8%

No opinion32.8%


4.7%


0.0%


7.8%

How long do you think the European NPL market will remain active?

0% leveraged —all cash buyer

37.3%

1%–25% leveraged

3.3%

26%–50%leveraged

19.7%

51%–60% leveraged

24.6%

61%–70% leveraged

13.5%

More than 70% leveraged

1.6%

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%




Notes

1. Loans are considered non-performing once they are 90-plus days past due or in nonaccrual status.

2. Special servicers are troubled loan specialists who oversee billions of dollars of commercial mortgages on behalf of CMBS investors.

3. “Quarterly Banking Profile, All Institutions Performance, Fourth Quarter 2012,” FDIC, www2.fdic.gov/qbp/2012dec/qbpall.html, February 2013.

4. “Bank Failures in Brief,” FDIC, www.fdic.gov/bank/historical/bank.5. Robin Sidel, “Wads of Cash Squeeze Bank Margins,” The Wall Street Journal,

online.wsj.com/article/SB10001424127887324581504578233650100037048.html, 11 January 2013. Deposits figure provided by Market Rates Insights Inc. Loan-to-deposit ratio provided by SNL Financial.

6. Loans that have gone bad over time.7. “US Capital Trends, The Big Picture: Overview Across All Property Types,” Real

Capital Analytics, Year in Review, 2012.8. Dakin Campbell, “U.S. Bank Deposits Drop Most since 9/11 Terror Attacks,”

Bloomberg, www.bloomberg.com/news/2013-01-23/u-s-deposits-post-biggest-drop-since-9-11-as-fdic-ends-support.html, 23 January 2013.

9. Robin Sidel, “Wads of Cash Squeeze Bank Margins,” The Wall Street Journal, online.wsj.com/article/SB10001424127887324581504578233650100037048.html, 11 January 2013. Deposits figure provided by Market Rates Insights Inc.

10. Shayndi Raice, “Business Loans Flood the Market,” The Wall Street Journal, online.wsj.com/article/SB10001424127887324449104578314140876408204.html, 19 February 2013.

11. “Buyers and Bleeders,” Invictus Consulting Group, invictusgrp.com/products/Invictus-Bank-Analytics-Buyers-And-Bleeders.php, 24 October 2012.

12. Phil Izzo, “Scant Pickup in Economic Growth Seen for 2013,” The Wall Street Journal, online.wsj.com/article/SB10001424127887324906004578289843768297184.html, 7 February 2013.

13. “Commercial Real Estate Vacancies Slowly Declining, Rents Rising,” National Association of Realtors, realtor.org/news-releases/2012/10/commercial-real-estate-vacancies-slowly-declining-rents-rising, 26 November 2012.

14. “Commercial Property Price Index,” Green Street Advisors, 7 January 2013.15. “US CMBS Delinquency Rate Falls to Lowest Rate in Almost a Year,”

Trepp,www.trepp.com/2013/01/31/us-cmbs-delinquency-rate-falls-to-lowest-rate-in-almost-a-year, 31 January 2013.

16. Beth Mattson-Teig, “Lower Rates Stoke Borrower Demand for CMBS Loans,” National Real Estate Investor, nreionline.com/finance/cmbs/lower_rates_stoke_borrower_demand_01302013, 30 January 2013.

17. Al Yoon, “Commercial-Mortgage Market Gets Frothy,” The Wall Street Journal, online.wsj.com/article/SB10001424127887324712504578131203625923548.html, 20 November 2012.

18. Beth Mattson-Teig, “Lower Rates Stoke Borrower Demand for CMBS Loans,” National Real Estate Investor, nreionline.com/finance/cmbs/lower_rates_stoke_borrower_demand_01302013, 30 January 2013.

19. Rance Gregory, “In commercial real estate, the other shoe(s) are falling,” Portland Business Journal, 4 September 2012 via Factiva © 2013 American City Business Journals.

20. “U.S. Banks’ Bulk Loan Sales to Grow, Aid in NPA Reduction,” Fitch Ratings, www.fitchratings.com/gws/en/fitchwire/fitchwirearticle/U.S.-Banks’-Bulk?pr_id=782581, 12 February 2013.

21. According to the FDIC, under a loss-share agreement (LSA) with the buyer of a failed bank, the FDIC guarantees the buyer that it will cover a share of the loss on a bank’s pool of commercial real estate loans or other pools of assets. The FDIC typically will reimburse 80% of losses incurred by the acquired assets on covered assets up to a stated threshold amount. For commercial assets, the SLA covers an eight-year period, with the first five years for losses and recoveries and the final three years for recoveries only.

22. Terry Pristin, “American Real Estate Investors Seek Opportunities in European Debt Crisis,” The New York Times, www.nytimes.com/2012/09/19/realestate/commercial/american-real-estate-investors-seek-opportunities-in-europes-debt-crisis.html, 18 September 2012.

23. Dalie Fahmy, “Germany to Sell Real Estate to Lone Star for $1.4 Billion,” BloombergBusinessweek, www.businessweek.com/news/2012-12-12/germany-sells-commercial-buildings-to-lone-star-for-1-dot-4-billion, 12 December 2012.

24. A house divided: how Europe views prospects for real estate investment, Ernst & Young. www.ey.com/Publication/vwLUAssets/A_house_divided_How_Europe_views_prospects_for_real_estate_investment/$FILE/EMEIAMAS_1309_TAS_Real_Estate_Investment_Indicator.pdf.

25. Sarah Krouse, “Investors Pick Over Distressed Property,” The Wall Street Journal, 8 January 2013. http://online.wsj.com/article/SB10001424127887323706704578229473736967146.html#

26. Craig Karmin, “Sales Pace Quickens for Troubled Assets,” The Wall Street Journal, online.wsj.com/article/SB40001424127887324445904578282801609767108.html, 5 February 2012.

27. “Nonperforming Loan Workshop,” EMEA Real Estate Conference, Ernst & Young, January 2013.

28. Paul Mouchakkaa, “Synchronicity III? The European Sovereign Debt Crisis and Implications for Commercial Real Estate Lending,” Morgan Stanley, www.morganstanley.com/realestate/SynchronicityIII.pdf, 2012.

29. Laura Noonan, “Moody’s warns European banks need more cash,” Reuters, www.reuters.com/article/2013/01/24/us-europe-banks-idUSBRE90N0HH20130124, 24 January 2013.

30. Ernst & Young Eurozone Forecast: outlook for financial services, Winter 2012–13, published in collaboration with Oxford Economics, www.ey.com/GL/en/Newsroom/News-releases/News_Bad-loans-and-regulation-will-squeeze-Eurozone-banks-in-2013.

31. “Bad loans and regulation will squeeze Eurozone banks in 2013,” Ernst & Young, www.ey.com/GL/en/Newsroom/News-releases/News_Bad-loans-and-regulation-will-squeeze-Eurozone-banks-in-2013, 7 January 2013.

32. Ibid.33. European Banking Barometer, Autumn/Winter 2012, Ernst & Young, www.

ey.com/Publication/vwLUAssets/European-banking-Barometer-Autumn-Winter-2012/$FILE/European_Banking_Barometer_Autumn_Winter_2012.pdf.

34. European Non-Performing Loan Report 2011, Ernst & Young, www.ey.com/Publication/vwLUAssets/European_Non-Performing_Loan_Report/$FILE/European%20NPL%20Report%202011.pdf

35. Anne-Sylvaine Chassany, “Hedge Funds Have $74 Billion as Europe Fire Sale Delayed,” Bloomberg, www.bloomberg.com/news/2012-08-13/hedge-funds-have-74-billion-as-europe-fire-sale-delayed.html, 13 August 2012.

36. Jack Ewing, “Economists Warn of Long-Term Perils in Rescue of Europe’s Banks,” The New York Times, www.nytimes.com/2012/02/13/business/global/low-interest-loans-to-european-banks-prompt-concern.html , 12 February 2012.

37. Harry Wilson, “Bank shares rise after relaxation of liquidity rules,” The Telegraph, www.telegraph.co.uk/finance/newsbysector/banksandfinance/9786470/Bank-shares-rise-after-relaxation-of-liquidity-rules.html, 6 February 2013; “Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools,” Bank for International Settlements, www.bis.org/publ/bcbs238.htm, January 2013.

38. Sarah Krouse, “Investors Pick Over Distressed Property,” The Wall Street Journal, online.wsj.com/article/SB10001424127887323706704578229473736967146.html, 8 January 2013.

39. Ernst & Young Eurozone Forecast: outlook for financial services, Winter 2012–13, www.ey.com/Publication/vwLUAssets/FS_Eurozone_Winter_2012/$FILE/FS_Eurozone_Winter_2012.pdf.

40. Loan portfolio transaction markets: United Kingdom and Ireland Update, Ernst & Young, year-end 2012.

41. “Fitch Says UK Banks to Face Muted Earnings,” Dow Jones Newswires; FoxBusiness.com, www.foxbusiness.com/news/2013/01/24/fitch-says-uk-banks-to-face-muted-earnings, 24 January 2013.

42. Ed Hammond and Jamie Smyth, “Irish banks push sale of real estate debt,” Financial Times http://www.ft.com/intl/cms/s/0/c819fee4-6703-11e2-a83f-00144feab49a.html, 25 January 2013.

43. NAMA website, www.nama.ie.44. “Anglo Irish Bank debt deal gets ECB clearance,” BBC News Business, www.

bbc.co.uk/news/business-21361339, 7 February 2013. 45. Patrick Gower, “Ireland launches biggest ever sale as It liquidates IBRC,”

Property Week, 22 February 2013.46. Ed Hammond and Jennifer Thompson, “Lloyds to sell £1.2 billion of distressed

debt,” Financial Times, www.ft.com/intl/cms/s/0/1c04dd1c-34aa-11e2-8b86-00144feabdc0.html, 22 November 2012.

47. Ernst & Young Eurozone Forecast: outlook for financial services, Winter 2012–13, www.ey.com/Publication/vwLUAssets/FS_Eurozone_Winter_2012/$FILE/FS_Eurozone_Winter_2012.pdf.

Global real estate services contacts

Country real estate services contacts

Howard Roth Global Real Estate Leader Phone: +1 212 773 4910 [email protected]

Rick Sinkuler Global Real Estate Markets Leader Phone: +1 312 879 6516 [email protected]

Christopher Seyfarth US Phone: +1 415 894 8738 [email protected]

Daniel Mair Germany Phone: +49 6196 996 24703 [email protected]

Mathieu Roland-Billecart UK Phone: +44 20 7951 5206 [email protected]

Ian Cosgrove UK Phone: +44 20 7951 1054 [email protected]

David Frias Spain Phone: +34 0915 725 086 [email protected]

Luke Charleton Ireland +353 1 221 2103 [email protected]

28

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EYG No. DF0157 1301-1011650 ED None

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