At the start of the Covid pandemic, real estate analysts were largely in agreement that hospitality and retail real estate assets were likely to increasingly feature in non-performing loans (NPLs), credit lines where borrowers have been in arrears for an excess of 90 days. The dynamics of lockdowns, travel restrictions and the rise of e-commerce and remote work placed hotels and shopping malls on the front line of Covid casualties, as structures remained vacant for long periods, and some assets underperformed for several quarters.
Unsurprisingly, the last two years have seen a fair number of NPL portfolios trade featuring hospitality assets, even as the effects of the pandemic subside. Investors including HIG Capital have purchased hotel-backed NPLs in Greece, perhaps the country worst hit by rising stocks of NPLs during the Global Financial Crisis (GFC), to the point of representing a major structural weakness for Greece’s banks. Meanwhile, last summer, Fortress spent €500 million on Spanish residential and hotel NPLs.
Although NPLs in the hotels sector in Greece remain widespread, and investors continue to comb through soured portfolios in Spain, Portugal and Italy backed by hospitality assets, there are some suggestions that both the overall quantity of bad loans and their associated risks are decreasing.
Distress risk
The European Central Bank’s latest Supervisory Review and Evaluation Process shows that the non-performing loans (NPL) ratio excluding cash balances at central banks and other demand deposits remained stable at 2.28 per cent in the fourth quarter of 2022. Both the stock of NPLs and loans and advances excluding cash balances decreased, to €339 billion and €14,873 billion respectively.
Aggregate stage 2 loans, those which are underperforming but not yet non-performing and thus often signal what might be to come, decreased to 9.63 per cent (down from 9.82 per cent in the previous quarter), as a share of total loans. This reversed part of the increase observed during 2022, assuaging the fears of some market watchers.
However, it is also true that the distress risk for European property has not gone away. A recent global investor survey from JP Morgan classified CRE as the “most likely cause of the next market crisis”, in a story that echoes previous cycles.
It was sour loans, after all, that precipitated the GFC, and spiked once again during the Covid crisis, albeit at less impactful levels. As a proxy for the relative health of the banking sector, NPLs are unlikely to entirely recede from sight in the current murky outlook.
Financial crack
Last week’s summit between the International Monetary Fund (IMF) and the World Bank in Washington may have yielded few comments – at least publicly – about the potential for another financial crack weeks after the demise of Silicon Valley Bank, but inflation and commercial real estate (CRE) were flagged as two key cogs in a larger, potential time bomb.
IMF managing director Kristalina Georgieva said there was a need “to monitor risks that may be hiding in the shadows, in banks and non-bank financial institutions or in sectors such as CRE”, while the IMF said that globally, real estate was attracting “growing concerns” given its significant dependence on smaller banks.
European risks are not quite on a par with US risks. The IMF calculates that the direct exposure of European banks to CRE was some 6 per cent of bank loans in 2022, versus a much more significant 18 per cent in the US. In total, around $270 billion in commercial real estate loans held by US banks are due over the course of 2023, with some $80 billion underwritten by the struggling office sector.
But risks abound in Europe, too. The speed of recent interest rate hikes have unbalanced banks’ asset bases, while Nordic and German banks are increasingly under the spotlight for their significant exposure to real estate. Southern Europe’s banks, conversely, are in more cautious territory compared to the GFC days.
“European banks are in a much better position this time round with larger reserves against potential losses; if you look at the tier one capital ratios, especially in countries like Italy and Spain, it has stepped up tremendously," says Massimo Bianchi, head of special situations real estate at illimity Bank.
Outperforming hospitality
The other lure of Southern Europe is its outperforming hospitality sector, with 2022 matching 2019 volumes and figures for 2023 already exceeding pre-pandemic levels. This is one of the reasons that NPLs backed by hotels in countries like Greece have continued to find buyers in the present market; the fundamentals of the assets remain of significant interest. Greek investor Invel has found success in the region with its ‘two-pronged’ investment strategy, pursuing both “luxury hotels, and large, resort-style hotels with branded residences,” according to Alexis Pipilis, Invel’s head of acquisitions in the Hellenic region. “The luxury segment fares better during market downturns as it is typically less affected by global macroeconomic situations in the short term,” he notes.
Still, when business plans do fail, there is always another party ready to pounce. Private equity firms such as Davidson Kempner have made billions extrapolating assets mired in distress. And research from law firm Garrigues confirms that those trading in NPL portfolios are getting better at selecting deals to ensure maximum profit. Profiling last year’s activity in Spain, Garrigues said that a series of very small transactions alongside jumbo transactions allowed firms to focus on “positions in very specific debts or assets, with one or two natural buyers… to increase their recovery rate”.
The other piece in the puzzle is the banks themselves, who are less likely to be surprised by a tsunami of bad debt. “Banks today should be much better placed to manage NPLs than after the GFC, owing to the EBA Guidelines on non-performing and forborne exposures and higher supervisory standards,” notes Eric Cloutier - partner at the KPMG ECB office in Frankfurt.
Cloutier says that high levels of dry powder are expected to drive NPL transactions and securitisations higher in 2023, as “we expect banks to use active deleveraging strategies, tackling distressed exposures quickly”. He adds: “As pressure mounts on the real estate market, we also anticipate a dynamic level of transactions for this segment, both for NPLs and foreclosed assets.”
Yet within the property landscape, hospitality owners are relatively confident that hotel-related risks have significantly receded. While Capital Economics forecasts that savings amassed in the UK during the pandemic are likely to run out this year, putting pressure on leisure spending, including holidays, the firm thinks this may prompt a rise in domestic breaks. It also notes that although hotel rents are still set to fall this year, echoing the broader picture in Europe, hospitality assets should outperform the wide leisure sector with growth of 0.8 per cent per annum from 2023-2027.