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Distressed real estate – Opportunities and risks in the German real estate market
Global | Publication | 六月 2023
The state of the transaction market for German commercial real estate
After the long booming phase in the real estate market, in which the annual transaction volume grew from EUR 10.45 billion (2009) to EUR 68.3 billion (2019) (source: CBRE), the volume for commercial real estate transactions in Germany decreased noticeably within the last 18-24 months. According to CBRE, the transaction volume shrank to EUR 59.2 billion in the first pandemic year of 2020. After, the German market seemed to recover a little in 2021 (EUR 62.1 billion) with the transaction volume decreasing further to EUR 52.3 billion in 2022.
Cushman & Wakefield’s research shows that the office sector saw a reduction in transaction volume of around 27% from 2021 to 2022, while the transaction volume for logistics and industrial properties still increased slightly by 4%. During the first quarter of 2023, according to the broker network German Property Partners (GPP), the transaction volume of commercial real estate for the seven largest German cities amounted to approximately EUR 2.6 billion, which corresponds to a minus of 72% compared to the same quarter of the previous year. According to further research by Cushman & Wakefield, the overall German investment market for commercial real estate reached a transaction volume of EUR 5.1 billion in the first quarter of 2023.
This means that the first three months of 2023 were the weakest start to a year since 2010. The main reasons for the current decline in transaction volumes in the real estate market are considered to be the strong increase in interest rates on loans as well as other political and economic factors such as increased construction costs, supply shortages, higher energy costs, planning in politics for climate protection measures on buildings, which are leading to uncertainty and unforeseeable costs, as well as the effects of the COVID-19 pandemic and the ongoing war in Ukraine.
In addition to risks, this current change in the real estate market also offers many opportunities for potential investors, which this series of articles entitled “Distressed Real Estate” will deal with in more detail.
The state of rents for German commercial real estate
In the leasing market, leasable space remains available in the market for longer at present with the rents increasing more slowly. A study by the Institute of the German Economy dated April 02, 2023 showed that one in four listings for office properties is on the market for an average of 38 weeks. In particular, office properties away from prime locations are currently no longer in as high demand as before. Office properties in the countryside of cities or in rural areas are frequently affected by the decline in demand. Centrality continues to be of great importance, particularly for office properties. According to the Institute of the German Economy, in 2022 rents for both office and retail properties as a whole lagged behind the rate of inflation. While office rents increased by 5.9% and retail rents by 6.2% in 2022 compared with the previous year, the inflation rate in Germany for 2022 is 7.9%.
The demand in the office property market is also due to the change in the office routine of many employees, who have increasingly made use of the option of working from a home office since the start of the pandemic. Employers are increasingly opting for new offices and modern and mobile working models against the backdrop of making savings on office space and replacing it with new innovative office concepts, such as multispace offices and desk sharing, which offer a higher degree of variability and flexibility and are adapted to the individual needs of the tenant.
Pre-insolvency or insolvency real estate acquisitions and NPL portfolio transactions as alternative acquisition options
As a result of the rise in interest rates, investors who rely on debt financing for real estate are currently holding back on transactions in the German market. The other uncertainties mentioned above are also contributing to the collapse in the transaction market mentioned at the beginning. There are currently differing opinions as to when the crisis on the real estate market will come to an end. In view of the increased construction costs, political and economic uncertainties and higher interest costs, as well as problems with refinancing, it is to be expected that an increasing number of property owner companies will experience financing problems in regard to existing properties or ongoing project developments. The first restructurings are already underway, some known and some unknown. Property owners will increasingly see themselves forced to sell and offer their properties on the market for a lower purchase price. On the other hand, mortgagees will be put in a position to foreclose on the property if their claims can no longer be met.
Against this backdrop, many potential investors are looking around for alternative acquisition options and opportunities in the current crisis situation. It can be assumed that the acquisition of real estate in advance of a potential insolvency or from an active insolvency from real estate non-performing loans (NPLs) will become increasingly prevalent and important.
Acquisition in advance of an insolvency in an (impending) crisis situation
The acquisition from a potentially crisis-ridden real estate owner takes place at a starting point like any other real estate acquisition; whether as an asset deal or as a share deal. Nevertheless, in these transactions it is important to pay special attention to specific risk situations. The main risk to be avoided results from the possibility of a rescission under insolvency law in the context of subsequent insolvency proceedings. In extreme cases, this can lead to the acquired property having to be transferred back to the insolvency administrator. The reclaiming of the purchase price, on the other hand, can only be filed in the insolvency table, which leads to only a proportional satisfaction. Transactions in which the buyer knows about the seller's crisis situation (or is aware of indications thereof) are particularly risky. At least after due diligence, it will often be assumed that a buyer could see indications that the seller was in crisis, i.e. that his insolvency was at least imminent.
Against this background, in the case of a real estate acquisition outside of insolvency, it is advisable to make use of various precautionary protection mechanisms which can exclude, or at least significantly reduce, the risk of avoidance in insolvency, whereby the conclusion of the purchase agreement and the performance acts undertaken for its execution are separately contestable. The precautionary protective mechanisms include, in particular, evidence prepared by independent third parties of the appropriateness of the purchase price (e.g. by means of a fairness opinion) and of the non-existence of an incurred or threatened insolvency of the subsequent insolvency debtor (e.g. by means of an IDW S 11 expert opinion). In addition, the existence of a serious and promising restructuring concept (e.g. by means of an IDW S 6 expert opinion) could and should also be documented if there are indications of the need for restructuring. If the performance obligations are fulfilled at the time of closing concurrently (Zug um Zug) as owed and originally agreed, or in any case in a direct temporal context, and if there has been no change in the appropriateness of the purchase price since the signing, the purchaser is already largely protected against challenges to the acts of transfer on this basis.
Special attention should also be paid to the question of securing claims arising from the purchase contract. For guarantees and tax exemption claims, it may be advisable to take out a Warranty & Indemnity (W&I) insurance policy. In case of fixed risks, which are generally not covered by W&I insurance, other forms of security, such as retention of the purchase price, etc., may be considered.
Acquisition in course of insolvency
For the realization of the property in course of insolvency proceedings, either the foreclosure auction via the enforcement court or the private sale on the market by the insolvency administrator can be chosen.
In a foreclosure auction, the highest bidder wins the award and becomes the owner by virtue of a sovereign act. The process is subject to strict rules and procedures under the German Compulsory Execution Act (Zwangsvollstreckungsgesetz, ZVG).
An alternative to the foreclosure auction, which is not regulated by law, is the sale by private contract by the insolvency administrator. The property is offered at the open market in order to achieve the best possible sales proceeds. The other conditions, such as the timeframe, can also be mutually agreed by the parties involved.
The acquisition of a property by way of a foreclosure auction or by way of a private sale by the insolvency administrator generally offers the purchaser the opportunity to acquire the property on more favorable terms. In return, it should be noted that in the case of a foreclosure auction, the purchaser is not entitled to a warranty pursuant to sec. 56 sentence 3 ZVG. Even in the case of a sale by private contract, the insolvency administrator will usually not agree to the assumption of extensive guarantees or indemnification obligations and will rather exclude or limit its warranty obligations insofar as legally possible.
In this respect, the examination of the legal and economic risks of a property within the framework of the advance due diligence to be carried out plays an important role. On the other hand, due to various deadlines and the need for quick liquidity, it is often necessary for the buyer to carry out the due diligence particularly quickly and efficiently, especially in the case of transactions during a corporate crisis. Ultimately, due diligence increases the chances of the potential investor being able to agree purchase price reductions due to risks found in the property. A security can also be taken out here, if necessary, through the conclusion of an W&I insurance policy. While the purchaser enters into the existing leases by operation of law, this form of acquisition gives the purchaser the opportunity to withdraw from uneconomical lease agreements on the basis of the special rights of termination pursuant to sec. 111 (1) of the German Insolvency Code (Insolvenzordnung, InsO) and sec. 57a sentence 1 ZVG after acquisition of the property from the insolvency administrator or award following foreclosure auction.
Acquisition of NPLs (non-performing loans)
According to the winter survey of the NPL Barometer (December 2022), published by the Bundesvereinigung Kreditankauf und Servicing and the Frankfurt School of Finance & Management, risk managers at German banks expect the stock of NPLs to grow to EUR 35.3 billion by the end of 2023. At the end of 2024, the volume of NPLs is expected to be EUR 38.1 billion, according to the survey - an increase of 24% from September 2022. At the same time, regulatory pressure has been exerted at EU level on credit institutions for several years to reduce their NPL ratios.
In times of decreasing real estate investments, the growing NPL market provides a possible option for potential investors to have the banks' securities, which often consist of real estate, transferred as part of the NPL transaction. In this way, the acquirer is also enabled to obtain real estate (or other assets) as collateral that would not otherwise have been available for sale.
It should be noted that in Germany the liquidation of the property serving as collateral does not result in the creditor becoming the direct owner of the property. Rather, the realization of the property takes place by way of a foreclosure auction or a private sale, whereby such an acquisition can in principle also take place by the NPL acquirer itself. In addition, potential acquirers pursuing a so-called loan-to-own strategy can first acquire the debts of a company and then, with the consent of the debtor, convert these into equity of the company (so-called debt-to-equity swap) and in this way ultimately secure control over the company. Furthermore, there is the chance that the acquired share in the company will increase in value, e.g. after a restructuring of the company.
While in the past the aim of NPL transactions was often still to realize the loan collateral in the short term by way of timely foreclosures, the general focus on the principle of sustainability can now also be transferred to the NPL market due to the increasing attractiveness of ESG products: Potential investors have the opportunity to benefit not only from the direct realization of loan receivables but also indirectly through active management of the real estate serving as collateral by developing it into a higher-value asset in cooperation with the other stakeholders by implementing the right ESG strategy. Such an upgrading of the existing property, e.g. through the use of resource and environmentally friendly technologies in the context of a refurbishment, can contribute to a more profitable placement of the property on the market than a short-term forced sale of the current existing property in its non-ESG-compliant condition would allow. Moreover, the associated positive publicity effect for both the NPL seller and the NPL acquirer should not be neglected.
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