One of the consistent talking points since the onset of the credit crunch has been the overhang of undistributed property debt on banks' balance sheets and the possibility of real estate funds and companies investing in real estate debt as an alternative to direct property investment. This has been the case both in the UK and other EU jurisdictions.
Investing in real estate debt is looking increasingly attractive to investors who are unable to achieve their target returns by buying the underlying assets. The financial crisis has resulted in a number of deals not being financed (or refinanced) because of the lack of liquidity in the market. At the same time, fundamentally sound debt is being traded below par for reasons less to do with the underlying strength of the asset (or indeed to the borrowers themselves) but more to do with the fact that institutions have had to trim down their lending portfolios. The coincidence of these two factors has generated a lot of interest in real estate debt from funds that would normally limit themselves to direct property investments and the majority of property investors have given the idea at least some thought.
That said, even if investing in real estate debt looks attractive in principle, for a variety of reasons, it is not always straightforward and, whilst property investors will be experienced in assessing and structuring direct property investments, this does not necessarily equate to being an experienced real estate lender/debt buyer and investing in real estate debt requires additional expertise.
Set out below is a summary of some of the principal issues, common to the UK, France, Germany, Belgium and the Netherlands, that you should be aware of and take advice on before investing in real estate debt. There are a number of issues specific to each jurisdiction and these are summarised in the attached table. This is not meant to be an exhaustive list of issues.
- Fund formation – if you are raising a new fund, then you will need to consider whether the proposed investment parameters permit investments in cash products such as debt. Equally, an existing fund will need to consider whether the articles or rules of the fund are wide enough to allow it to buy real estate/real estate debt. In France, for example, objects clauses in existing funds tend to be narrowly defined so as to prevent them from buying debt at all.
- Regulatory Issues – the relevant regulatory position varies across the EU. In the UK, Belgium and the Netherlands for example, the regulatory regime tends only to be restrictive if you are investing in residential mortgages or taking deposits from the general public, although you should still seek specific advice as to whether other banking regulation laws may apply. This contrasts with the position in France and Germany where regulatory issues are one of the single biggest obstacles to overcome for a prospective investor in property debt. Key regulatory issues to consider in each jurisdiction are set out in the attached table.
- Due Diligence – the real estate collateral provided is obviously an essential factor in ascertaining the value of the debt to be acquired. At the time the relevant debt was underwritten various due diligence reports are likely to have been addressed to the originating bank. However, whilst copies of these reports are likely still to be available, they will need to be checked to see if reliance can be extended to a purchaser of the debt in a secondary market. Such reports may also require updating to reflect changes to the underlying property asset and as part of this process it will need to be confirmed whether the underlying rental income stream has changed materially. Separately from any real estate due diligence carried out, you will also need to satisfy yourself that the loan documentation to which you are becoming a party is in order and that any mortgage/charge taken over the real estate asset security is properly registered.
- Warranties - the extent to which a secondary market investor in real estate debt is likely to benefit from warranties from the selling bank will depend on the size and value of debt being acquired. For example, whereas a purchaser of real estate debt would not normally expect to benefit from any representations or warranties (other than very limited warranties such as the fact that the debt purported to be transferred does exist), an investor acquiring a portfolio of real estate debt is more likely to benefit from warranties.
- Inter-creditor issues – much of the property debt created in recent years has been packaged up into separate tranches of debt. The rights of the different lenders in respect of each tranche of debt are likely to be governed by separate inter-creditor arrangements, aspects of which will be unfamiliar to direct property investors as such arrangements are usually concluded between lenders without the owner/developer being a party. These inter-creditor arrangements are important, however, and, as the most interesting tranches of debt to investors may be the "B"/"C" tranches. These are priced at a higher margin and tend to be trading a significant discount but are more exposed to the risk of non-payment by the borrower and vulnerable to overriding decisions being made by the "A" lender under the relevant inter-creditor arrangements. The legal issues in inter-creditor arrangements can be complex and need to be fully understood as part of the due diligence process.
- Enforcement and Insolvency – if you are investing in distressed real estate debt with a view to acquiring the underlying property (ie to obtain a "loan to own"), then you will need to be familiar with how your taking ownership of the secured property could be achieved in practice. For example, the Borrower Protection Laws in Germany impose various statutory pre-conditions as to what constitutes an event of default, and this will have a significant bearing on any such "loan to own" proposals. There are also complex and time-consuming procedural rules governing the enforcement of land charges in Germany and Belgium of which you should be aware.
- Tax issues – as ever, tax structuring is key to ensuring your investment is tax efficient. Investing in debt brings additional complications as the buyer of the debt will be receiving interest rather than rental income from the property. Appropriate structures and vehicles will therefore need to be used and any cross-border issues (e.g. withholding tax due on cross-border interest payments) considered at the tax structuring stage. There are various issues specific to each jurisdiction to consider (e.g. real estate transfer taxes which can be as high as 6% in the Netherlands) on which you should refer to the attached table for a brief summary. Specialist tax advice should therefore be obtained for the particular set of circumstances of each transaction at as early a stage as possible.
- Other issues – there are some unusual issues in each jurisdiction which you need to be aware of in structuring any acquisition. For example, in the UK, unlike direct property investment, it is possible for binding agreements for the purchase of real estate debt to be concluded over the telephone; great care should therefore be taken when agreeing heads of terms. Another important point to be aware of is that there is a mandatory rule in France and Belgium that allows a borrower to pre-pay the loan by making a payment to the lender equal to any "below par" price paid for the acquisition of its debt; these statutory provisions could potentially be used by opportunistic debtors to the detriment of the acquiring fund.