Institutional investors and investment banks in the United States are increasingly taking a more global approach to real estate, scouring European markets for attractive acquisition opportunities.
While the level of completed transactions hardly constitutes a major wave, it may signal the beginning of a long-term trend. Pension funds have witnessed dramatic increases in their global stock and bond portfolios and consequently are finding themselves underinvested in real estate based on percentage goals.
Real estate investment funds - flush with capital - are "shaking the bushes and looking under rocks to place money already raised," according to Van J. Sults in London, managing director of international operations for Chicago-based LaSalle Partners.
French market draws attention
So far, most of the acquisition activity has occurred in France, where a growing number of American concerns are exploring ways to buy the troubled loan portfolios of French banks and insurance companies. The weak French economy has produced an opportunistic buying opportunity that has not been seen in the United States since the height of Resolution Trust Corp. (RTC) workouts in the early 1990s.
The market in France today "looks like the early l990s in the United States," says Squire Junger, worldwide director of real estate portfolio services for Arthur Andersen & Co., Los Angeles. Many of the same players - mostly insurance companies and banks - are over there with investors looking to purchase portfolios from institutions. "Just like there was in the U.S., there is a shortage of financing, unsure exit success and consequently high discounts and high returns," he says.
As of yet, there has been more exploration than activity. But nearly all of the major U.S. investors are taking interest and wanting to become active, according to Jeff
Giller, vice president and director of acquisitions and operations for Europe for J.E. Robert Cos., Alexandria, Va., an asset management and capital recovery services firm specializing in under-performing real estate, loans and operating companies. "Everybody is interested, but only a brave few have made capital commitments, and only a few have made deals. Just a handful have actually made a commitment to human resources, to participate and put up due diligence dollars," he says.
The total nonperforming loan market in France is estimated to reach the $40 million to $60 million range, and the amount of product is expected to provide a three-to four-year window of opportunity. Opportunistic buying could last even longer if the market continues, as it is now, in its inability to accommodate simultaneous transactions, Giller says. So far, transactions have typically seen three bidding teams who do not have the resources to do multiple deals. Until staffs are built up, transactions have to be run back to back, he says.
Junger says that he expects about four years of sales activity before the market sees a "maturation of buyers." At that time "the risks and rewards will decrease" as happened in the United States, he says.
Europe's first transactions
The first loan portfolio sale in France was completed in December 1995. Lehman Brothers teamed up with Cargill Financial and LaSalle Partners to acquire a portfolio of more than 200 loans with a book value of approximately $250 million from Barclays Bank of London, with Bankers Trust Co. serving as sales agent. The portfolio, which marked the bank's exit from the French real estate market, consists of a majority of the bank's commercial loan holdings: a mix of office, residential and retail property as well as land, most of which is located in Paris, according to Wilson Lee, senior vice president at Lehman Brothers, New York.
Lee, who is moving his base of operations from New York to London in anticipation of increased European activity and as part of the firm's plan to increase its global presence, says that the transaction represents a 50/50 co-investment between Lehman and Cargill. He says Lehman has been actively seeking French portfolios for acquisition since mid-year 1994, when the only American players in France were Lehman, Colony Capital, GE Credit Corp. and Goldman Sachs. But until the Barclays deal, "prices did not mesh," he says.
Three other French bulk sale transactions have also been completed to date and another is in the works. In June 1996, Whitehall Street Real Estate Fund, operated by Goldman Sachs, announced their intent to purchase a $750 million portfolio of distressed commercial real estate in France for approximately $250 million from Compagnie UAP, a major French insurance company.
In February, Whitehall, together with Shaftesbury International Holdings and Vines Management as European partners, purchased a $149 million portfolio from a unit of Compagnies de Suez, Paris. Whitehall's first French loan buy occurred in January, when the fund teamed with Westmont Hospitality Group of Houston to buy an affiliate of Credit Lyonnais that owns a portfolio of French hotels with 2,800 rooms. Bankers Trust served as marketing agent from the UAP and Suez transactions.
Lehman Brothers is now the lead bidder of three teams looking to purchase a portfolio of CrediSuisse, which consists of a mix of commercial real estate loans and development deals with a book value of approximately 21 billion French francs, according to Lee. The other partners in Lehman's team are Cargill and Cabot Square, which is a new fund with capital backing from CrediSuisse. A bid date is expected in the third week of September, Lee says.
Why the French market?
The market holds "enormous possibility," Lee says, explaining that France has been through a credit crisis similar to that which occurred in the United States in the early 1990s, putting banks under pressure to reduce their distressed loan inventory.
While there are similarities to the RTC period in the states, there are also many differences. Participants and advisers forewarn of the myriad complications of entering the French loan portfolio market. From stiff properly transfer taxes to a host of technical and legal issues, the pitfalls are many for those who are not well versed in loan workouts.
Lee says the market is no place for the inexperienced, who "could get hurt badly" because of weak information flow and complex legalities, which force the need for experienced local partners - and caution.
One major difference is the lack of government intervention in France. Instead of forming an RTC-type vehicle, the French government has injected capital into the government-owned Credit Lyonnais bank but has not taken over its assets, Lee says.
Giller of J.E. Robert says that it is "highly unlikely" that the French government, as it moves closer to European unification, will continue its support of the French banking system. In other words, much of the regulatory pressure that helped inspire the market in the United States is not evident in France. "Bank examiners took a strong stance against insolvent S&Ls in the United States. Once they were deemed insolvent, the government closed their doors and seized their assets. The government worked in a pro-active and efficient manner," says Giller, who is based in Paris. But in France, "regulators are not nearly as aggressive, and it does not appear that the government will take a further role in the mitigation of the problem. They are letting the banks work out the situation for themselves," he says.
"French culture, dynamics, customs, laws and tax structures are all different," says Sults of LaSalle Partners. "To be effective you need strong operating expertise. Forming a joint venture with a French entity helps cut through the problems." That is why LaSalle Partners decided to form an asset management partnership with Societe Generale known as Lafayette Parternaires.
J.E. Robert Cos. also formed such a partnership last year, Finestate & Robert, a real estate advisory firm based in Paris, with Company Finestate serving as a local partner.
Market challenges
Giller says one of the largest challenges in the French market is "understanding a very complex and very extreme tax system." High tax rates make it essential to create the proper structure and transfer vehicles. If the deal is put together correctly, one can end up paying almost no tax but, if structured wrong, the tax bill can end up being 20% to 30%, he says.
Giller mentions other problems, including the lack of adequate loan information from sellers. "Information most U.S. firms are used to having to conduct due diligence on a portfolio is much more deficient in France for a lot of reasons," he says. Banks have been sloppy in collecting information and loan covenants do not exist. "You don't have collateral information to price an asset as you do in the United States."
This translates into having to do a lot more "grass roots" due diligence. "You have to build rent rolls through a knowledge of tenants who probably do not have leases, and you must be willing to take risks on lease terms," Giller says, adding that another major difference in the French market is the structure of leases, specifically the common 3-6-9 lease, which allows most commercial tenants to terminate their lease agreement every three years. This is a major concern for underwriters, who must base pricing to factor in turnover costs.
The courts pose another possible problem, because the legal system has not been tested in terms of its methods for handling foreclosures and real estate-related bankruptcies.
"In the states you know the legal system and the time frame for unwinding a bankruptcy but, in France, you are faced with a system of laws that govern but are untested, with no precedents," Giller says. This results in a lack of confidence as to how much it will cost and how long it will take to get transactions through the courts, he says.
Despite all of the possible risks and headaches. the rewards can be great.
The discounted price of portfolio loans are typically in the range of 35% to 45% of the original face value, according to Lee, but such discounts may be misleading as some loans have already taken intermediate right downs. Opportunistic investors are seeking a 20% plus return on their capital, says Sults, who notes that those kind of opportunities have virtually dried up in the United States.
"The loan portfolio market in the United States has changed dramatically. It is now a deeper buyers' market with less inventory, as private sector banks have already unloaded most portfolios," Lee says.
That is leading many U.S. institutional investors to look for better opportunities abroad.
Pension funds reach out
French returns are stirring the attention of some U.S. pension funds, who will no doubt, over time, have more global real estate assets, following on the tails of their acquiring additional global stocks and bonds. It's the familiar pattern of real estate following other asset classes, Sults says.
Teachers Insurance and Annuity Association (TIAA), New York, has retained LaSalle Partners to explore ways to directly invest $50 million to $100 million in French commercial real estate, including Paris office buildings and other mainstream property types such as shopping centers and possibly industrial properties throughout France, according to Sults. TIAA intends to play an active role in both opportunistic portfolio buying as well as traditional direct investment, he says.
Bruce Miller, a lead partner at E&Y Kenneth Leventhal in San Francisco, which serves as a real estate consultant to California Public Employees Retirement System (CalPERS), says that E&Y KL is advising CalPERS on forming a co-investment strategy with an experienced investment bank or capital company to take advantage of the extremely high returns and the same type of yields they experienced when they were one of the largest portfolio buyers in the RTC arena earlier this decade. Miller says possible target markets, besides France, include Canada, Singapore, China, South Korea and Mexico.
Other market possibilities
Spain is another European market that has been capturing the attention of U.S.-based investors since mid-1995, although the country is yet to see any transactions. That is largely because Spanish banks "were far from being ready to recognize the losses and narrow the bid-ask spread. They may never be ready to be put into the position to accept the losses needed for their portfolios to clear the market," Giller says.
"Italy is even further behind Spain, because sellers there are better capitalized than in France," Junger says. Other participants mention possibilities in Germany and Belgium, whose markets have their own individual differences as well as a thin market in Sweden and some re newed interest in Asia.
"Germany is waiting in the wings. Their banks are becoming burdened with nonperforming real estate, and we should see bulk sales there within a year," Giller says, adding that Germany could produce a greater volume of portfolio sales than France.
"The German economy is in the pits, overexpanded due to the expansion of East Germany. Development of the East was expected to happen faster, and losses from speculative projects there that never went anywhere are a large problem," he says.
The United Kingdom holds the chance for acquisitions of operating companies more so than buying portfolios from financial institutions, Junger says.
Exit strategies for French and other European transactions run the gamut of possibilties, Less says. Options include restructuring loans with borrowers or taking over management of the assets in conjunctions with local property managers. Securitization is another possibility. Junger reports that buyers are carefully considering securitizing portfolios with Europe-based agencies and that U.S. rating agencies have established offices in London to be part of the action. "Some of the portfolios may go through the securitization process, but the market has not matured and is not as broad-based in Europe as it is in the United States," he says.
But so far there is no secondary market for financing. But, Giller says what might happen is that international capital sources will recognize the attractiveness of this market and will find they will be safe on a loan-to-value and debt-service coverage basis. "The rating agencies are all here and interested, and they need to spend moer time getting comfortable with the market in terms of rollover riskes and 3-6-9 leases and the amount of time it takes to get through the foreclosure process. They need to understand the risks better before they issue ratings. It will take a year of evolvement and workouts before we see securitization market development," he says.
Overall, market depth and longevity also depends on issues of prcing and process - and whether sellers are pleased. If the sellers are satisfied as well as the buyers, there will be far more deals, according to Lee. "But so far, the jury is still out. If people go through he bid process and then the seller does not want to sell at those prices, the market could dry up," Lee says.
James B. Frantz writes about real estate issues from his home in New York.