Europe's banks face growing pressure to offload bad property debt as the economic outlook worsens, capital rules get tougher and private equity firms take a hard-headed approach to the value of loan books bought from lenders like Royal Bank of Scotland.
Banks have never fully recognised the true fall in value of property in the wake of the financial crisis, hoping rents would continue to cover loan repayments. That position is now less tenable.
Last December, a fund run by private equity group Blackstone bought a portfolio of 30 property loans worth 1.4 billion pounds from RBS at a 30 percent discount. As many as half a dozen of these are likely to be in default within two months, setting a possible precedent for other sales, two sources familiar with the deal told Reuters.
Like ostriches, banks have had their heads in the sand but private equity firms are not part of that club, one of the sources said of the Blackstone deal. The defaults will be like the grown-ups arriving home during a kids party to ask 'what's been going on here?'
UK banks lent tens of billions of pounds against property during the profligate years before the credit crisis, much of it housing shops and offices outside the best locations, such as central London, which have suffered more in the economic slowdown.
Although sub-prime real estate lending caused the global crash, banks have adopted a so-called policy of extend and pretend in the hope values will recover rather than undertake a mass disposal programme at below book value that would hurt already under-pressure balance sheets.
New rules that determine how much capital banks have to hold against risky loans make that harder. Regulations such as Basel III and recent directives from the European Banking Association will trigger deleveraging of between 1.5 to 3 trillion euros in Europe, a report by property consultancy DTZ said on Thursday.
This week Spain's biggest three banks set aside 7 billion euros to cover bad property loans after government pressure this week for lenders to get to grips with the country's real estate problems.
The pressure on banks from governments to clean up their balance sheets has now become so huge that they'll just have to get on with it, said Paul Bacon, European chief executive of global property consultancy Cushman & Wakefield.
Add to that an estimated 550 billion euros of property debt in Europe will reach maturity in the next two years and you will undoubtedly see more loan sales, Bacon said.
You know more sales are expected when funds like Lone Star, Blackstone and Cerberus increase their staff numbers in Europe, said Glenn Rufrano, global chief executive of Cushman & Wakefield.
About 42 percent of the 201 billion pounds of loans secured on UK commercial property were at a loan-to-value ratio of more than 80 percent on June 30, a December report by De Montfort university showed.
That means the loan is worth at least 80 percent of the property it is borrowed against. Banks would not currently lend at above 65 percent, and so that portion of the loans are not refinancable, said the report's author Bill Maxted.
Banks know a fire sale would depress the whole market so there seems to have been a policy of ignoring loan-to-value breaches as long as the rents cover interest payments, said Investec analyst John Cahill.
The fact UK banks realise the country may be back in another recession and the fear real estate values may fall further will boost property loan disposals, an adviser to the banking industry on their property assets told Reuters.
A lot of what banks hold is secondary grade and will need the sort of care and attention banks can't always provide to avoid it just rotting, Cahill said.
RBS' sale of a so-called Project Isobel loan portfolio piled further pressure on banks because it failed to provide the template for less aggressive deleveraging many hoped it would.
The plan was to put the loans into an off-balance sheet special purpose vehicle and nurse them back to health using Blackstone's property expertise before both sold at a profit.
But talks hit the buffers last summer as the euro zone sovereign debt crisis escalated, and in the end, RBS had to provide a reported 550 million pounds of debt itself to fund the deal as banks including Goldman Sachs and HSBC were unwilling to.
Blackstone's 25 percent equity stake of 100 million pounds in the vehicle was the final sum RBS raised after a transaction that took more than a year to complete, a fact the banking adviser described as a bit of a disaster.
It's not much against the 30 billion of real estate loans the CEO wants to dispose of by 2013, the source close to the deal said. This took a large part of 40 or 50 people's time last year. Do the maths and ask yourself whether RBS would go down that route again.
The December sale by Lloyds Banking Group of a loan book known as Project Royal to US private equity group Lone Star would likely serve as a future template, the source said. Lloyds wrote down the value of a 900 million pound portfolio by 40 percent before selling outright.
'Royal' not 'Isobel' will be the way forward, the source said. Mark your book down, squeeze it out through the hole and move on.
(Reporting by Tom Bill; Editing by Chris Wickham)