Gifford West/SusanGolden 2024
Gifford West, Managing Director, Alpine Tremont LLC
German banks are more exposed to US commercial real estate loans than any other segment of European banks with an outstanding €285 billion against a EU total of €1.4 trillion. During the pre-COVID US real estate bubble, a cadre of German banks, seeking yield and diversification, financed ‘blue chip’ assets in New York, Chicago, San Francisco, Los Angeles and elsewhere with a particular focus on office loans. The risk seemed manageable with often a combination of conservative LTVs and rock-solid high-tech tenants (e.g., Amazon, Meta, LinkedIn, etc.). COVID was the black swan event that obliterated these assumptions, gutting demand for office space through a combination of remote work and corporate downsizing. A loan written in 2018 at a 60% LTV may now have an LTV of double that or higher.
A field trip to New York’s Wall Street, San Francisco’s Montgomery Street, or Chicago’s Loop is necessary to fully understand that US central business districts will not recover in the next two to five years. Without seeing the buildings in question, it is easy to imagine the panacea of residential conversion and/or repurposing to multi-tenant concepts.
Viewed up close, much of the existing office inventory is large footprint buildings with massive windowless cores and utility stack layouts making it impossible to reconfigure without prohibitively high investments. The worst of these buildings were designed around two obsolete concepts: massive trading floors and professional service firms where the partners had the windows and the junior staff dwelled in windowless cubes in the core.
It is easy to underestimate the grimness of the US’s central business districts from the comfort of a German office with natural lighting, a short commute home by bicycle, and a good bar and restaurant district within walking distance. The CBD model of pre-COVID is never going to return in the US; this is the market consensus from this side of the Atlantic.
German banks planning to hold these loans through to recovery have two options: active and passive. The active strategy may lead to a higher probability of a better outcome but will require substantial investment, active management in both the strategic and tactical decision making, and a minimum of a five-year time horizon. The bank will make a calculated bet as to when and what demand will be in five years; it will then execute this strategy through to 2030.
The passive strategy, while less costly in terms of management time, involves extending and pretending and is likely to lead to a faster deterioration of the underlying assets. There will be minimal capex on these properties, and, as leases mature, tenants seeking traditional space will be spoiled for choice and seek ever more aggressive terms on better spaces. Vacancies will climb, properties will become more thread worn, and the eventual exit will be more costly.
The good news for workout departments is that valuable lessons were learned from the German NPL crisis (2003-2007) and the GFC (2008). During the post reunification NPL crisis, German banks became Europe’s leaders in addressing non-core and non-performing loans through quick and efficient loan sales, selling in excess of €45 billion of loans through 100+ transactions. German banks were also leaders during the GFC, quickly selling non-core and non-performing loans both in foreign markets and their home market. This allowed these banks to focus on core activities and convince investors and regulators that their problems were being addressed quickly and efficiently.
It would be a mistake to assume that the German secondary market is a barometer of US secondary liquidity. The German secondary CRE loan market is a cyclical phenomenon. It first was born in 2003, then disappeared, then reemerged in the latter half of the GFC. It periodically shows moments of liquidity, but years have passed since significant volume traded.
In contrast, the US secondary loan market for performing and non-performing loans has been highly active and consistently liquid since shortly after the Savings and Loans Crisis in 1990. Within the universe of thousands of investors active in the US market, there are a critical mass of buyers for any type of loan. The key documentation has been standardized and the sale process, regardless of the size of the portfolio, can be completed in a few months. The investing funds active in this space have the expertise to renovate/repurpose buildings and the risk capital supporting them that has the appetite to take a five-year bet on where demand for these buildings will be in 2030. Sales are quick and the bid offer spread is manageable.
US office loans are a non-systemic risk confronting German banks that, while painful, will not be fatal. Many German banks do not have the resources in terms of management time or knowhow to manage through the five-year investment and repositioning of these assets. As in the past, an early exit is likely to best serve bank shareholders, staff, and regulators. Bank management should seize on the liquidity of the US secondary loan market to exit these problemed loans.
About the Author
Gifford West with York Kreft are the managing partners of Alpine Tremont LLC, a specialist advisory firm focused on working with lenders to value and exit non-core and non-performing loans. They both were instrumental in the creation of the German NPL market in 2003 and have conducted 100’s of NPL transactions in the US, Germany, the UK, Ireland, Italy, Spain and elsewhere.
