Albulus Advisors Germany/martinjoppen.de
Dr. Ruprecht Hellauer, CEO, Albulus Advisors Germany
Until about two years ago, real estate values had been increasing steadily for over a decade. As a result, most non-performing loans (NPLs) from the previous financial crisis had been resolved, causing the secondary market in Germany to dry up, and rendering NPL models (and workout skills) practically obsolete.
At Albulus, we adapted our business model accordingly, transitioning from a pure NPL investor to raising successful funds to acquire maturing senior real estate loans and even originate our own new loans. With all the current talk surrounding the next "wave" of NPLs, many market participants have asked us about this wave's potential size and impact—and whether it's time to revive our trusted NPL pricing tool.
At mid-2024, the consensus is that the general real estate market (excluding prime assets) is NOT headed for a rapid recovery. The market is anticipating more stress as low-interest-rate loans expire. According to CBRE and AEW, the "debt funding gap" is massive and will continue to grow until 2026, with Germany being particularly affected due to what were above-average real estate price increases. As NPL ratios rise on bank balance sheets and the first mezzanine loan funds fail, veteran market experts are predicting an impending NPL wave.
In Germany, distressed debt has in the meantime become an established asset class, supported by abundant capital (at various costs), specialised knowledge, and standardised market practices, making pricing and transactions more efficient than 20 years ago. Loan servicing has even been regulated by the "Kreditzweitmarktgesetz," underscoring the asset class's maturity.
Our team began investing in NPLs in 2005 and navigated through the Global Financial Crisis (the second wave). Now, we find ourselves in a familiar scenario—reminiscent of Bill Murray in "Groundhog Day." And while each NPL wave is unique, the patterns are strikingly similar. If you can recall the movie, then you’ve been around long enough in the market, and you likely experienced the first and second NPL waves alongside the Albulus team.
The first and current waves in Germany share similarities due to massive overinvestment in real estate, though for different reasons. Previously, it was driven by enthusiasm about tenant demand, triggered by reunification, and tax subsidies for investors. This time the overinvestment was supported by an abundance of "interest-free" senior debt, combined with "mezzanine" and "crowdfunding", all leading to Loan-to-Value (LTV) ratios sometimes exceeding 100%.
Up until 2022, nearly every real estate development plan appeared feasible on paper. However, this crisis is not primarily driven by a lack of tenant demand but by the increased costs of debt and equity, making these projects financially unviable. This re-financing issue links the second NPL wave and the current one—it's not broken real estate, but broken balance sheets. Unlike before, many loans offered to Albulus have recently defaulted or are on the verge of default, and are secured mainly by undeveloped land and unfinished projects.
Interestingly, this time around, the banks are NOT struggling for survival. Highly regulated post-GFC, banks have limited themselves to lower LTV loans, and have recently increased profitability with rising interest rates, enabling them to build necessary reserves and dispose of loans without being overwhelmed. This contrasts with the second wave when over-leveraged banks, unable to secure unsecured funding, had to offload loans in an illiquid secondary market with significant discounts. Now, it’s the mezzanine funds and junior debt providers who will bear the brunt of the market reversal.
So, where are the opportunities in this cycle? Firstly, with banks focused on extending existing loans, newly-originated senior loans secured by stable, cash-flow-producing assets present an attractive risk-return profile. This is an ideal environment for smaller private debt funds to benefit from the "debt funding gap." At Albulus, we capitalise on this by originating purely senior loans and avoiding higher risks from offering "whole loans" or "mezzanine loans" to meet our investors' return targets. Senior debt now offers higher contractual returns than real estate, with significantly lower risk.
Secondly, Albulus is raising its second "extend the runway" or "Landebahnverlängerer" fund to acquire maturing real estate loans. The increase in interest rates combined with regulatory pressures leading banks to offer maturing senior loans at a discount, results in even more attractive returns for debt fund investors. These returns are mezzanine-like, but the loans acquired are significantly less risky, being senior secured with LTVs around 60% on average. Investors receive a return premium for the stigma of maturing loans, without chasing premiums through excessive structural subordination risks.
Despite the attractive risk-return profiles of performing and maturing senior loans, there remains a case for dusting off the trusted NPL models—but with some additions. Models should now include capabilities to price development projects and handle the complexities introduced by junior loans.
There is a substantial supply of loans secured by stalled projects in various stages of development. With residual values for some sites being negative for the development projects originally planned, and carrying costs for developments significant, lenders will have to accept substantial haircuts on senior loans secured by land and halted projects, with junior or mezzanine loans likely suffering even more.
Investing in these situations requires stamina, developer expertise, and fresh equity, as mezzanine financing is no longer widely available.
Our investors advised us to "Stop being depressed" during the first NPL cycle 20 years ago, leading us to incorporate hard-linked market growth assumptions into our NPL model. Given the current bid-ask spread for these loans and the cyclical nature of the real estate market, we recommend using market growth assumptions in development models to stay competitive and creative. "Build a better mousetrap" was another key lesson learned from 20 years ago; and today's multi-layered financing structures will definitely require innovative approaches.
About the Author
Dr. Ruprecht Hellauer is the CEO of Albulus Advisors Germany GmbH.
