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After an active 2011 for nonperforming loan (NPL) sales, 2012 was off to a frustratingly slow start. However, distressed commercial loan activity is now picking up again for both non- and sub-performing loans. In its fourth year, the latest Ernst & Young NPL survey, At the crossroads: Ernst & Young 2012 real estate nonperforming loan investor survey, reveals some interesting trends about the investor perspective about where things might be heading. But first, let’s take a look at the state of the banks and the stage they set.

State of the banks

In some ways, things are looking pretty good for the banks. Bank profits are up and loan loss reserves are down. Bank failures are declining. Given this environment, we expect to see the banks restructuring more loans in 2012, with more “extend and pretend” strategies continuing.

At first, this may not bode well for distressed loan sales. But there is more to the story. For one thing, the FDIC continues to close failed banks. When it does, the FDIC looks to sell those banks, along with the banks’ portfolios of loans, including both performing and nonperforming loans. The FDIC is expected to remain an active seller, although possibly less than in 2011 and recent years. But there will continue to be bank closures and, therefore, bank and loan sales.

Another major potential driver of loan sales is the $1 trillion of looming loan maturities over the next five years. Banks, not wanting even more NPLs to be added to their balance sheets, may opt for a selling strategy. The pressure from the upcoming maturities could urge banks to more actively sell their NPLs, which are currently estimated to be in the $100-billion range.

Further, US banks, particularly smaller ones, are gaining more attention from investors. While there are always exceptions, the smaller banks usually have a higher concentration of commercial real estate on their balance sheets, which clearly has been a major source of distress. According to the FDIC, among the top 100 banks, commercial real estate represents only about 7% of the balance sheet. This is in notable contrast to the remaining 7,345 banks, where commercial real estate represents over a fourth (26%) of the total.

US bank CRE loans, Q3 2011

Source: http://www.fdic.gov

While the increased perceived health of the banks is one sign that banks may undertake a hold strategy, there are a number of signs that they may instead sell. In fact, those banks that have completed asset sales have seen rises in value compared to their peers, with the market choosing them to recognize and reward them for those actions.

Investor outlook

Given all of these factors, what do investors think? In the aggregate, it appears investors believe that 2012 will be equally active as 2011 for NPL sales, although individual investors are somewhat split on what that level of activity will look like. Banks are becoming more comfortable in acquiring loans, especially with increased pressure to put capital to work. Chris Seyfarth, an Ernst & Young partner who spearheads our NPL survey, believes investors are in a good place to move forward with deals. Investors “are optimistic that the NPL market will remain active for another 24 to 48 months.” This is likely for a number of reasons.

First, as discussed above, banks have a number of reasons to keep adding to the supply of distressed loans in the marketplace. Investors’ frustration in prior years was often the lack of supply and the lack of options. 2011 brought back some of that supply, and it may continue.

Second, with investors finding improved deal success rates, they are further encouraged to pursue distressed debt. In 2011, an increasing number of investors allocated more capital to buying NPLs from banks, and they had a high rate of success in closing transactions. In fact, two-thirds of those investors pursuing loan sales reported closing transactions in 2011. This is compared to less than half during the year before.

In addition, the availability of acquisition financing is a good thing for deal flow. Lenders are increasingly interested in financing loan acquisitions, both performing and nonperforming. 67% of investors expect some leverage in a deal, although this is down from 84% in 2010. Few investors expect more than a 60% loan-to-value (LTV) ratio, with about a third hoping for LTVs in the range of 51% to 60%.

Finally, abroad, many investors are also excited about the distressed debt prospects that Europe offers. With the ever-present European debt crisis, more European banks are restructuring their balance sheets, bringing more distressed loan portfolios to market. US investors benefit as it widens the pool of investment opportunities and offers potentially higher returns than what can be achieved in the US.

The coming years

While the outlook for distressed loan sales continues to be mixed, investors generally believe the NPL market to remain active over the next two to four years. Banks still have high numbers of NPLs with more coming, and investors are experiencing improving success rates, all of which means that it is likely more deals will get done in 2012 and the coming years.

Brett D. Thompson is a principal with Ernst & Young LLP’s Transaction Real Estate practice. He may be reached at [email protected]. The views expressed are those of the author and not necessarily those of Ernst & Young LLP.