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Italy's non-performing loan market rolls on while investors wait for a new wave of distressed real estate assets. By Robin Marriott

Italy has managed to deliver its fair share of shocks in recent times. From former Prime Minister Silvio Berlusconi's indictment on fraud charges to the relegation of its top football teams for matchfixing, the country can always be relied upon to deliver the unexpected.

One of the constants, though, is its economic performance, which has lagged behind much of the rest of western Europe. In 2005, GDP growth stood at zero, a significant decrease from an already sluggish 1.1 percent the year before. The new center-left government is promising to do something about the malaise via a €35 billion ($45 billion) reduction in the country's budget deficit, hoping to achieve it the end of 2007. It also plans to open up some of Italy's closed businesses to competition in order to promote efficiency. In addition, there are hopes that the country's unexpected World Cup win will provide a short-term boost to the economy.

It is not just in the arena of politics and football, however, that the country has managed to produce shocks. Property has been affected too. In July, the government announced plans for a controversial tax that could have led to “distressed” property sales. Romano Prodi's administration considered replacing the existing recoverable VAT system with a 10 percent non-recoverable stamp duty on real estate deals. The most draconian plan was to apply retrospective VAT on deals backdated to 1998, which would have placed significant burdens on real estate investors. However, the government is set to water down the proposals, leaving investors to hunt for property deals with more confidence.

Property and distress have been bedfellows in Italy ever since the mid- to late-1990s when opportunity fund managers led by Morgan Stanley, Fortress and Goldman Sachs began buying portfolios from banks looking to clean up their balance sheets. In 1999, the Bank of Italy introduced a special law allowing Italian banks to securitize their bad loan portfolios.

One of the most notable deals of that era occurred a year later, when Morgan Stanley Real Estate Fund bought the mortgage bank Fonspa. The transaction gave the investment bank around 20,500 loans backed by residential or industrial property with an outstanding balance of €577 million.

LOANS FOR SALEA selection of recent Italian NPL transactions

Buyer Seller Size (m)
Merrill Lynch/Fortress Banca Intesa €9,000
Morgan Stanley/Pirelli RE Banco Nazionale del Lavoro €345
Goldman Sachs Banco Nazionale de Lavoro €294
ABN AMRO Sanpaolo €270
Lehman Brothers Banca Monte dei Pashi di Siena €197
Pirelli/Calyon Banco Popolare di Verona e Novara €195
Pirelli Banco di Sicilia €2,300
Pirelli Morgan Stanley €2,600

Despite shocks to the system and the prevalence of NPL portfolios, the Italian real estate market is not systemically distressed.

As in the rest of Europe, property values have risen, there is a huge amount of liquidity in the country and new funds are still being raised.

In June, Cordea Savills launched an opportunity vehicle called Italian Opportunities No. 1, a closed-end Luxembourg vehicle targeting up to €200 million in equity. The fund is aiming to make a 20 percent annual return.

Justin O'Connor, chief executive of Cordea Savills, says: “Most people have invested in Rome and Milan, but we feel there is a lot of potential in investing outside.”

Among its deals is the €23 million purchase of a 61-unit residential tourism site in Sardinia, where the company is selling off apartments one by one to owner occupiers.

O'Connor says investors have done well in Italy because the property market has been on a “good run” due to yield compression.

“To enjoy continued good returns will require the working of assets such as repositioning them via refurbishment or redeveloping them for change of use,” he says.

While office deals are still taking place, investors are looking more and more towards industrial property as a safe haven, according to Carlo Bruno, a real estate advisor at the Milan office of law firm Ashurst.

“Investors are looking to diversify their investments and industrial property has been seen as a safe alternative,” he says, “It appears to be a more steady sector, less touched by the potential fluctuations of the market.”

“Development of sites is also becoming popular among investors who are looking for deals which are becoming more and more specialized,” he adds.

But the feeling among some private equity firms is that many investors paid too much for development sites two years ago, and these might become the distressed sellers of tomorrow.

In addition, like other parts of Europe, a crowded market and rising prices mean that any economic shock to the system could catch investors out at the top of the cycle.

In April, Italian property company Beni Stabili beat a field of 70 to buy the €1 billion COMIT Fund portfolio of properties consisting mainly of assets in the center of Milan, but it is selling smaller portfolios to private investors anecdotally borrowing 95 percent of the purchase price.

These too could become “distressed” if interest rates rise and rents tumble.

The bigger question for now though is whether the Italian market will become depressed rather than distressed in the face of much greater interest in other parts of the world, including Germany, eastern Europe and Asia.

NPL activitiy in select European markets

Germany started slowly in addressing its NPL problems, but now has an active NPL market. As of February 2006, international investors are thought to have closed on no fewer than 25 sales totaling at least €24 billion. German banks are still aggressively cleaning up their balance sheets.

Until recently, Poland's banks have had little incentive to dispose of NPLs partly because of limited liquidity problems. In 2004 it introduced the Investment Funds Act and altered tax regulations for banks giving them new opportunities to dispose of NPLs.

Careless lending led to a big NPL problem and the creation of a state-sponsored work-out and consolidation agency, Ceska Konsolidacni Agentura, in 2001 to bail out the post-Communism banks but its mandate expires in 2007.

Remains relatively quiet despite proposed banking reforms in the wake of the 1998 financial crisis as the economy gathers strength.

Small market but there is no real rental market so if economy continues to remain flat, job losses mount and interest rates rise there could be more mortgage-backed NPLS.