DISTRESSED REAL ESTATE ASSET

MANAGEMENT
IN
BANKING
ORGANIZATIONSStrategies and organizational structures to
address the challenges of real estate collateral management in times of high
NPL ratios and volatile real estate markets

THE NEED FOR A PROFESSIONALIZED REAL ESTATE

ASSET MANAGEMENT APPROACH IN BANKS
In the current stagnant European macro-economic scenario, most banks have seen their volumes
of defaulted loans grow exponentially as bank customers have experienced increasing difficulties
in paying off their debts.
The impact of higher volumes of non-performing loans on the balance sheets of banks is
particularly dire in regions with difficult real estate market conditions, such as Southern and
Eastern Europe (e.g. Italy, Greece, Balkans)[House Price Index, Eurostat, 2014], or in regions
facing the aftermath of real estate bubbles (e.g. Spain, Ireland). During real estate bubbles the
number of real estate construction sites sharply increases and the price of real estate properties
soars, fueled not only by an increasing demand for properties but also by the speculation that
demand itself will stay strong and that real estate prices will continue to grow. With increasing real
estate market prices, the volume of real estate project finance operations and mortgage loans
granted by banks rapidly grows, driving up the capital reserves that banks need to set aside to
cover potential future loan defaults. When it becomes clear that real estate forecasts are not as
positive as expected and market demand starts to decrease, real estate prices plunge and in
case debtors default on their loans, banks face increasing capital requirements through these
defaulted loans and will eventually need to write-off part of the exposure. In case of real estate
bubbles, these effects are even more significant due to the losses on the market value of the real
estate collateral.
Needless to say that in the last years, as the overall European economic conditions worsened,
the regulatory pressure on banking organizations has at the same time increased, in particular on
the accuracy of the methodologies used by banks for the accounting and reporting of collaterals,
as demonstrated by the recent asset quality review run by the European Central
Bank [Aggregate Report On The Comprehensive Assessment, European Central Bank, 2014].

This scenario of tougher economic conditions and stricter monitoring from regulatory watchdogs
has urged a growing number of banks to reassess the operating model they use to manage their
portfolio of distressed real estate assets (i.e. the pool of real estate assets the bank has booked
as collateral for its non-performing loans). The goal is to identify the areas (e.g. functions,
policies, decision-making bodies, etc.) where a more competent real estate management
approach should be applied.
This need has become particularly relevant for medium and large banking groups, with a
significant portfolio of distressed real estate assets spread over multiple countries and
subsidiaries. As real estate management is typically a non core business for financial institutions,
banking groups tend in fact to lack the competences (e.g. in evaluating real estate asset quality,
in forecasting real estate markets outlook, etc.) and the organizational structures (e.g. dedicated
internal divisions, policies and procedures, etc.) required to steer a coordinated real estate
collateral management strategy within the group.

TARGET STRATEGIES FOR DISTRESSED REAL ESTATE

ASSETS
From zeb perspective, strategies to be applied to the portfolio of distressed real estate asset
depend on the quality attributes of each individual real estate property (e.g. real estate segment,
status and condition of construction, use of building and vacancy rate, etc.) and on the real estate
market development potential or, in other words, the expected development of market prices for
the particular real estate segment (e.g. commercial building, hotel, agricultural land, etc.) in a
given country.
To this end, zeb has designed and developed a comprehensive set of decision criteria in the form
of a scorecard logic matrix, used to assess the portfolio of distressed real estate assets. Similar
to scorecards designed to assess loan applications from clients, zeb real estate asset selection
model weighs up different individual real estate and market attributes according to pre-defined
weightings and scorings, preliminarily aligned with the bank during a setup phase.
Properties of high asset quality (e.g. finished property in excellent condition and high rental yield)
and with a promising market outlook (i.e. expected market price increase for the particular real
estate segment in a given country) are considered as properties with upside potential, thus

suggested to be repossessed by the bank from the defaulted client, actively managed (e.g. earn
rental income from current/prospect tenants, maintain/develop the property, etc.) and sold after a
potential market recovery in the medium term (e.g. 3 to 5 years) (cf. figure 1: strategy 1). Given
the extent of the distressed real estate portfolio, the bank might in fact consider the opportunity to
directly manage and develop a number of high quality real estate assets (especially in case of
increasing market prices). However, an in-depth investment case (including DCF analysis) should
be conducted for such properties in order to confirm a potential positive cash flow for the bank
(i.e. positive sum of initial investment for repossession, incomes and expenditures during the
banks tenure, final selling price, etc.). Also, considering the non-core banking nature of such
strategy, a preliminary alignment with the regulator on investment strategies and capital
requirements is considered to be crucial. In particular, the bank should not miss to inform the
regulator that this strategy is only valid for a restricted period (3 to 5 years) and only for properties
with high quality, for which a future sale to external investors at an increased market value is
considered very likely and is indeed the mid-term goal.
Lacking specialized real estate asset management skills and a structured approach to identify
properties with upside potential, most banks still tend to pursue a fast run-down strategy for their
real estate collaterals (cf. figure 1: strategy 2). This strategy implies the sale of real estate
collateral through in-court or out-of-court enforcement proceedings with the aim for the bank to at
least partially recover the losses on defaulted loans. This also means to accept a significant lower
selling price, since this strategy attracts bargain hunters trying to buy real estate properties below
their market value. Ideally, this approach should only be considered in case of properties without
upside potential (e.g. properties in bad condition, with high vacancy rate, etc.), properties still in
early construction phase or properties with negative real estate market outlook (in the given real
estate segment / country) in order to limit the losses on the value of the collateral. Finally, this
strategy might also be applied if the exposure for a particular loan is significantly lower than the
collateral market value and can then be covered by the price achieved in the enforcement
procedures.
As a third option, in case the bank would assess that the enforcement of the property would
generate an insufficient selling price, the bank might consider to repossess a property without
upside potential with the sole goal to sell it within a short time (e.g. 1 to 2 years) at a price higher
than the current enforcement value (cf. figure 1: strategy 3). In no case the bank should anyhow
embark in large-scale investments for the development of this property during the period of

tenure, as no positive market outlook is forecasted for the specific real estate segment/market.
The main advantage of this third strategy compared to the fast run-down approach is that the
bank would have sufficient time to initiate and conduct a proper sale process to sell the property
at the current market value.

strategies for distressed real estate assets

Figure 1: Target

BOOKING
AND
SERVICING
OF
REAL
ESTATE
COLLATERALS: TARGET REAL ESTATE MANAGEMENT
ORGANIZATION
In order to enable a dedicated management of distressed real estate properties, real estate
collaterals with upside potential are suggested to be transferred to the books of newly founded
entities (development SPVs). These legal entities have an approved separate line of funding and
are used to repossess the properties from defaulted clients and then sell them to external
investors in the medium term. The number of so-called development SPVs and the composition
of their portfolio of upside potential properties should be tailored in a way to meet the
requirements of potential investors, based on their preferences for future equity deals. Investors
typically adhere to one of the following categories: (i) institutional investors (e.g. pension funds,

state funds, real estate investment funds), interested in single properties or small portfolios with
cash flows from rental income in a long term perspective; (ii) financial investors (e.g. private
equity or hedge funds) interested in large portfolio deals with strong risk / return preference and
short / medium-term perspective or (iii) strategic investors (e.g. real estate developers, hotel
chains, etc.) with real estate management as their core business and interested in the
development of single properties.
Real estate without upside potential should instead continue to be booked on the books of the
local bank subsidiary where the defaulted loan had originated or alternatively on the books of
newly founded run-down SPVs.
Development SPVs and, if founded, run-down SPVs are established with the sole intention to be
the legal vehicle for the transfer and disposal of properties, meaning that they should not bear a
dedicated staffing pool and they should be closed as soon as their portfolio of distressed real
estate assets has been sold. According to zeb approach, a fully-fledged real estate management
organization (cf. figure 2), with a clear separation of tasks and responsibilities across functions
and a specialized line of staffing, should in fact be designed within the existing bank organization,
to ensure a strong governance over distressed real estate management strategies and
processes.
Based on best practices observed during past project experiences, an effective real estate asset
management organization should consist of a central unit established at group level and of local
servicing units established in the individual countries with a significant portfolio of distressed real
estate assets. The main responsibility of the central unit is to steer the entire real estate collateral
management organization (e.g. approve investment budget, define strategies, supervise local
units, etc.) and to report to the management board of the banking group. Local units are instead
responsible for the operational management of the portfolios of distressed real estate assets,
applying comprehensive know-how and an established network in the local market. Local units
provide indeed the most typical real estate management services such as portfolio management
(e.g. property valuation, portfolio analysis, real estate asset selection, etc.) and, in case of
properties already repossessed, property management (e.g. vendor management, property
maintenance, etc.) and asset management (e.g. tenant management, investor search, etc.).

Figure 2: Target
real estate asset management organization

CONCLUSIONS: THE CONTRIBUTION OF AN EFFECTIVE

REAL ESTATE ASSET MANAGEMENT ORGANIZATION TO
THE BANK BUSINESS RESULTS
Endangered by difficult market outlooks, with volatile real estate market prices and increasing
ratios of non-performing loans, banks could benefit from the setup of a specialized organization
dedicated to the management of distressed real estate assets. Besides bringing in a more
transparent and effective approach to deal with distressed real estate assets (e.g. for real estate
valuation, real estate management, real estate exit strategy definition, etc.), such an organization
could also help to improve the business and financial results of the bank. On the one hand by
supporting all kinds of distressed real estate management strategies, a well functioning internal
real estate asset management organization could contribute to a consistent reduction of nonperforming loans. On the other hand, depending on the specific composition of the portfolio of
distressed real estate assets (e.g. high share of upside potential properties), real estate
management strategies could even generate an additional profit line for the bank, based on the
rental income from repossessed properties and on the successful future sale of properties at a

mark-up price. It goes without saying that these strategies should represent a secondary
business model for the bank and that a specific share of entrepreneurial risk should always be
considered as the development of real estate markets heavily depends on the overall economic
outlook of the respective countries.