The return of the non-performing loan

The headlines currently dominating the property market do not make for comfortable reading and suggest a very negative outlook: namely, falling prices, a retreat into other more lucrative markets and fewer and fewer transactions.

But if you take a closer look, you will see that the reality is actually very different. Yes, the number of real estate transactions has declined and many traditional investors are choosing to sit back and wait to see how the market adapts before buying and selling assets. However, one area is seeing an increase in transactions: non-performing loans (NPLs).

NPLs are currently being traded at levels rarely seen before, not just by private equity firms and hedge funds but also by specialised boutiques tailoring products for institutional investors.

This is a turnaround for the market. For years now, we have observed falling NPL-quotas in the publicly reported EBA Risk Dashboards. At the end of 2022, the NPL Ratio in the European Union fell to 1.8% of all bank loans accounting for a volume of €357bn, even in highly leveraged sectors such as real estate. But as many government debt relief programmes set up during Covid come to an end, we will see a rise in NPLs and restructuring efforts as many borrowers default on their loans.

On our Drooms platform, we have already seen a 25% increase in NPL-related transactions. Banks, as well as private debt funds, are currently trying to optimise their risk profile, while specialised investors embrace the opportunity to acquire loans at a large discount and in anticipation of high returns, if repaid in full. Once the asset is stabilised, investors can expect an immediate cash flow. Failing loans can also grant investors access to real estate assets at discounted rates.

Many NPLs are backed by properties as securities, providing an effective protection against capital loss and even offering an interesting option for real estate investors to get hold of properties at much lower costs.

Consequently, the majority of NPLs sold and bought in the real estate market are developments with a high leverage and loans to private equity and hedge fund firms.  Typically, these firms have had a tendency to engage in the fix and flip game in recent years and thus are familiar with working with high leverage and short-term-credits. As those loans are seldom sufficiently equity-backed, the risk of default is rising.

However, investors who are hoping to capitalise should be careful. Investing in NPLs is highly complex and requires expertise, market knowledge and thorough due diligence. A comprehensive due diligence process should be based on a full understanding of potential issues and pitfalls, which are often not obvious to an inexperienced buyer.

It is best to work with an experienced team which has a strong track record of managed NPL portfolios and has a sound legal, financial, real estate and market expertise. The availability of good data quality is also crucial. All relevant information regarding the borrower and the collateral must be collected, structured, and made available in an easy-to-handle format for all parties involved in the process.