Investors hunting for higher yields are turning their attention to Europe, where a substantial pipeline of distressed commercial real estate debt is poised to hit the market.

Bad real estate loans have taken a back seat to the broader Eurozone crisis. But, as the European financial markets finally appear to have found some solid footing, attention is shifting to resolving legacy real estate loans.           

According to a forecast by PricewaterhouseCoopers, banks are expected to sell off an estimated $19.5 billion this year in non-performing commercial real estate loans, which represents a 20 percent increase compared to the $16.2 billion worth of loan portfolio sales that occurred in 2012.That could very well be just the tip of the iceberg.

“Where we see Europe today is where the U.S. was in 2009. It is in the very early stages of its loan resolution business,” says Peter Nicoletti, executive managing director, global note sales, in Jones Lang LaSalle’s capital markets group in New York City.

As the volume of distressed commercial real estate debt in the U.S. continues to decrease—and and prices increase—investors are shifting their focus to new buying opportunities in Europe. Europe has a sizable and growing market for non-performing loans (NPLs) with an estimated $1.3 trillion of NPLs now on the balance sheets of the region’s banks, according to an Ernst & Young 2013 report on the market that was released last week.

“There is a pretty big spotlight on Europe in terms of the NPL market,” says Christopher Seyfarth, a partner in Ernst & Young LLP’s transaction real estate practice. “So particularly for the larger opportunity and real estate funds, they see Europe as an early market, but a potentially very, very large market.”

New regulatory requirements and banks increased focus on profitability could motivate banks to sell more NPLs in the coming year. Ernst & Young cites data from the Oxford Economics Research that predicts that NPLs in Europe will reach a high of $1.3 trillion in 2013.

Buyers chase opportunities

U.S.-based private equity firms such as Blackstone Group, Cerberus Capital Management, Lone Star and Kennedy Wilson are leading the push into Europe. Those large investment groups will likely pave the way for other mid-sized buyers that are waiting in the wings. “We see the mid-tier private equity players starting to create partnerships and trying to determine where they want to be in Europe,” says Nicoletti.

The large private equity funds in particular are not newcomers to Europe or to the risk associated with acquiring distressed assets. “They are pretty adept at assessing risk and then pricing it accordingly,” says Seyfarth. According to the Ernst & Young report, pricing on NPLs sold in 2012 in the U.K. and Ireland range from a low of 20 percent to a high of 90 percent below the outstanding loan amount.

So far, lenders have been slow to mark those sub- and non-performing loans to market, especially when it comes to their own sovereign debt. In addition, the situation in Europe is more fragmented than in the U.S. with European countries applying different mandates on how they are going to approach their bad book of loans, notes Nicoletti.

However, that tide is clearly shifting. The Ernst & Young report predicts the biggest opportunities, at least in the near-term, to emerge in the United Kingdom, Ireland, Germany and Spain. The primary source of those portfolio sales will be the banks. In Europe, about 75 percent of outstanding commercial mortgage debt is held by banks compared to 55 percent in the U.S.

For example, London-based Lloyds Banking Group dominated the market in 2012 for NPL portfolio sales and continues to bring deals to market in 2013. In February, Lloyds sold a sizable portfolio of NPLs secured by German retail real estate. The face value was $1.1 billion, and it attracted a number of global investors before it was ultimately acquired by Marathon Asset Management, a U.S.-based hedge fund.

Such sales activity is expected to widen and spread to other banks in 2013. Yet resolution of these distressed assets in Europe is murky and will vary by country to country, notes Nicoletti. At least initially, investors are gravitating towards the United Kingdom and Germany where laws are similar to that of the U.S. Ireland has been very active as well. In February, for example, the European Central Bank cleared a plan for Ireland to liquidate the former Anglo Irish Bank now known as the IBRC.

As the market develops and opportunities continue to arise, investors will likely move into Spain and Italy. However, investors may wait for more clarity or understanding on the Euro Zone resolution before there is a big influx of buyers into those markets, notes Nicoletti. In Spain, for example, the government has created SAREB, a “bad bank” designed to acquire NPLs from other Spanish banks. “They are really not going to be in a position to start disposing of—or even understanding—what their real estate loans are really valued at for another 12 months,” he adds.

Although in its early stages, SAREB has started buying up to $117 billion of NPLs and other assets, according to Ernst & Young.

As the European NPL market continues to evolve, the expectation is that there will be more regulatory pressure for financial institutions to sell their non-performing loans and their sub-performing loans. The question remains as to what the timing will be and how swiftly banks will be required to act to get distressed mortgages off of their balance sheets.

Investors believe that the opportunities to buy NPLs in Europe could go on for three to five years or longer. “It is too early to tell who is going to be successful over there and who is not, or the types of investors,” says Seyfarth. “One thing for sure is that it is a significant opportunity, and I think investors big and small will be focused on Europe.”