Oliver Platt
Oliver Platt, managing partner at ARCIDA Advisors and real estate finance partner at KUCERA
The consequences of the COVID 19 pandemic, the Ukraine crisis, real economic events such as increased demand for home office concepts or changes in retail consumer behavior, expected discounts of up to 30 percent in real estate values (and associated covenant breaches), increasing loan expiries as well as new regulatory requirements will foreseeably lead to a further increase in distressed debt and growing NPL transaction numbers in Germany. Already, Germany is one of the European markets that has actually seen an increase in NPL volume from EUR 29.7 billion in December 2021 to EUR 31.6 billion in December 2022. If we further consider the development outside the regulated banking world (e.g. debt and mezzanine funds), which have often granted subordinated financing without sufficient collateral, we arrive at a realistic German NPL volume totaling EUR 80 - 100 billion for the year 2024, according to our estimates.
For loan buyers and servicers, corresponding opportunities arise in Germany - whether directly via the acquisition and liquidation of the loan receivable or indirectly via active management of the real estate serving as collateral (with active consideration of ESG criteria).
Reasons for the Awakening of the German NPL Market
The start of the Russian war of aggression on Ukraine in February 2022 set in motion a spiral that has now also affected the real estate sector. Inflation rose along with higher energy costs. The ECB had to take countermeasures and raised key interest rates in several steps to 4% (June 21, 2023) - further interest rate steps are expected. Money therefore has its price again. In addition, construction prices have risen drastically, as the real estate industry is energy-intensive and supply chains are causing massive problems. It is therefore expected that there will be a major wave of insolvencies in the coming months, especially among companies that bought at peak prices. Creditreform already reported in June 2023 that 8400 company insolvencies were registered between January and June of this year. This was 16.2% more than in the first half of 2022.
The risk of increased loan defaults can initially be limited by the positive capitalisation of German credit institutions. As of March 2021, German banks held EUR 150 billion in excess capital, i.e. core capital above the capital buffer and minimum requirements. In principle, they can draw on this capital to absorb losses while continuing to grant loans. However, EU regulations such as the Rules on the Regulatory Ultimate Protection for Non-Performing Risk Positions (so-called NPL backstop) will have an impact and attack the capital resources of credit institutions. These aim, among other things, to reduce the high level of non-performing risk positions or to cover them completely by means of risk provisioning within a certain period. In the event that the risk provisioning falls short of the minimum coverage requirement, the difference is to be deducted from the bank's Common Equity Tier 1 capital. The EU regulation has an enormous scope: It applies not only to NPLs by definition but also to so-called forbearance measures such as deferrals, suspensions of repayments or moratoria. This means nothing other than the end of the banks' "extend and pretend"-strategies.
There are further regulatory catalysts: The 6th amendment to the Minimum Requirements for Risk Management in Banks (MaRisk) provides that institutions must comply with stricter requirements for NPL management as soon as they reach the threshold value of 5 % of NPL’s within their portfolio. For example, they must develop a strategy for managing and reducing NPL positions and align their processes, such as the handling of problem loans, accordingly. BaFin and Deutsche Bundesbank will shortly publish the 7th amendment to MaRisk. In the future, institutions will be required to carry out their new real estate lendings on the basis of a tightened risk analysis as well as realistic valuations and also to adequately review their existing properties and real estate projects - in particular also with regard to ESG compliance. An even more conservative leverage in lending is expected.
Also, the purpose of the EU Directive on Credit Servicers and Credit Purchasers, which is to be transposed into national law by December 2023 at the latest, is to facilitate the sale of NPLs between banks and debt buyers, but at the same time to protect borrowers as fully as possible. The measures provided for in the directive promote the development of an "awakened" professional secondary market for NPLs: Loan buyers should be able to purchase NPLs throughout the EU without restrictions.
Ultimately, the implementation of IFRS 9 requires higher and earlier risk provisioning for loans compared with IAS 39, and it can be assumed that the losses expected in some cases will exceed the amount required by regulatory requirements. This leads to necessary impairments and increases the pressure on banks to find solutions for such loans - a further motivator for sales.
Solutions for Dealing with the increased German NPL Volumes
Future solutions must be defined in the context of the changing financial, regulatory and real estate landscape in Germany. It is already clear that it will be necessary to look at the issues from a new holistic perspective. Ultimately, this must be done by creating a broader partnership that involves all stakeholders – both at the level of the loan as well as at the real estate level. New thinking and challenging outdated conventions must become the norm, especially as ESG principles have such a fundamental impact on the way business must be done today and in the future. The major financial institutions, through their risk management teams, are already actively seeking creative solutions and partners capable of implementing such strategies in the future.
Therefore, the establishment of partnerships between financial institutions and private, specialised loan servicers and loan buyers is seen as a necessity and an economically viable option. Such partnerships are already being discussed intensively today.
Partnerships can be formed not only with the financial institution, but also with the borrowers ("fresh money aspect"), the NPL acquisition finance lenders, and the communities where the secured properties are located ("fresh money leads to sustainable properties that are consistent with the urban development mandated by the communities"). This necessary partnership aspect leads to the following thought: Investments used to be judged and selected solely on the basis of their pure economic success. In the recent past, this has changed. The principle of sustainability, divided into the three ESG assessment categories (environmental, social, governance), has also found its way into the world of NPL investors. In general, the NPL industry has learned from the experience of the first NPL wave in the early 2000s and is ready to implement ESG strategies: Protecting borrowers' rights plays a more important role in NPL management. Among other things, this also avoids reputational damage for the loan buyer, its loan servicer and ultimately the investors behind it.
The German NPL market has already expanded and will continue to grow. Banks are now forced to find a solution for NPLs. There is a clear and distinct potential for investors to work with investment advisors and servicers to tap into this market. Therefore, it should be considered as an alternative part of any investment strategy: Both the German NPL market offers the opportunity for diversification and the opportunity to gain value indirectly or directly as an investor.
About the Author
Oliver Platt is a managing partner at ARCIDA Advisors and a real estate finance partner at KUCERA.