9M 2013 Eurocastle Investments LTD Earnings Conference Call

Nov 14, 2013 AM EST
ECT.AS - Eurocastle Investment Ltd
9M 2013 Eurocastle Investments LTD Earnings Conference Call
Nov 14, 2013 / 05:00PM GMT 

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Corporate Participants
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   *  Andrew Dempsey
      Fortress Investment Group LLC - Managing Director
   *  Francesco Colasanti
      Fortress Investment Group LLC - Managing Director
   *  Steve Charlton
      Eurocastle Investment Limited - CFO

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Conference Call Participants
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   *  Edmond Safra
      EMS Capital - Analyst
   *  John Britton
      Select Equity - Analyst

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Presentation
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Operator   [1]
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 Good morning. My name is Jodie and I will be your conference operator today. At this time, I would like to welcome everyone to the Eurocastle third-quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions).

 I would now like to turn the conference over to Mr. Andrew Dempsey, Managing Director at Fortress. Please go ahead.

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 Andrew Dempsey,  Fortress Investment Group LLC - Managing Director   [2]
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 Thank you, Jodie. Good afternoon. I would like to welcome all of you to Eurocastle's third-quarter 2013 earnings call. Joining us today are Francesco Colasanti, Managing Director at Fortress covering Fortress's European real estate-related investments, and Steve Charlton, Eurocastle's CFO.

 This call is being recorded and the replay number is on our website. This call is also available via webcast on our website, which is www.eurocastleinv.com.

 I would also like to point out that statements, opinions and beliefs communicated today which are not certain historical facts may in fact be forward-looking statements. Our ability to predict results or the actual outcomes of current actions and future plans is limited. Although we believe that the expectations reflected in any such statements are based on reasonable assumptions, our actual performance and results may differ materially from those set forth in any estimates, projections or expectations expressed in any statement we make and for any past performance or result.

 In addition, references to past trends or activities should not be taken as representation that such trends or activities will continue in the future. Eurocastle does not undertake any obligation to update any such statements, which generally speak only as of the end of third quarter 2013. With that, I would like to turn the call over to Francesco Colasanti. Francesco?

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 Francesco Colasanti,  Fortress Investment Group LLC - Managing Director   [3]
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 Thank you, Andrew. Welcome, everyone, to the Eurocastle third-quarter 2013 earnings call. First, I would like to mention that, like the previous call, through the duration of this call we'll be referencing a presentation that we have posted on our website under the financial information section, which we hope you will find helpful.

 As I mentioned in the previous call, the first half of the year was very transformational and very productive for Eurocastle. Our focus during the third quarter has been to manage the first two investments in the new strategy, realize the highest possible value from our legacy business and build up a pipeline to invest the remaining cash available of Eurocastle that currently is approximately EUR130 million.

 We will review all of this in the following parts of this presentation, but now I will turn it to Steve for a summary of our financial results for the first nine months of this year. Steve?

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 Steve Charlton,  Eurocastle Investment Limited - CFO   [4]
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 Thank you, Francesco, and welcome, everyone. I will spend a few minutes reviewing the financial highlights set out on slide 2 of the presentation. More details are contained in the appendix as well as in the financial statements for the nine months released this morning.

 After adjusting for the convertible bond conversion and capital raise earlier in the year, the pro forma NAV at the end of 2012 was EUR12.61 per share, mainly as a result of some asset-specific valuation events within the legacy German commercial real estate and debt investment portfolios. Eurocastle's NAV at the end of September was EUR372.3 million, or EUR11.41 per share. This compares to net assets at the half-year-end of EUR378.4 million, or EUR11.60 per share.

 Italian investments and available corporate cash accounted for EUR4.31 per share, while the NAVs in the German real estate and debt businesses were EUR5.28 and EUR1.82 per share, respectively.

 Eurocastle recorded net losses of EUR61 million for the nine months from EUR7.5 million for the third quarter, largely as a result of fair value movements in the German real estate portfolio and impairment charges in the debt business. Excluding these valuation changes and also excluding gains and losses on asset sales, normalized FFO for the nine months was EUR15 million. This compared to normalized FFO of EUR4 million for the comparable period in 2012, in part reflecting lower base management fees starting from the second quarter of the year.

 Slide 14 shows the breakdown of FFO and normalized FFO between the Group's business segments, as well as separating the German real estate business into nonrecourse portfolios that are freely cash flowing and those that are currently cash trapped by the lenders. The normalized FFO for the Italian business and for the cash flowing legacy portfolios was EUR8.3 million for the nine months and EUR4.9 million for the third quarter. That is after absorbing all corporate overheads.

 From a pure cash flow perspective, taking into account cash released from asset sales, year-to-date cash distributions to the topco from the legacy portfolios was EUR27.6 million, of which EUR26.4 million came from the German real estate business. This is shown in more detail on slides 9 and 10.

 Now turning to dividends. In line with our previous guidance to reinstate quarterly dividend payments at a level of EUR0.50 per annum starting from the third quarter, a dividend of EUR0.125 per share was declared at the end of September and paid at the end of October.

 With this, let me turn it back to Francesco for an update on Eurocastle's business and outlook for the fourth quarter.

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 Francesco Colasanti,  Fortress Investment Group LLC - Managing Director   [5]
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 Thank you, Steve. So as you can see on page 3 of this presentation, today, Eurocastle's business is split between two core segments, the Italian investments on one side and legacy business on the other side.

 The Italian investments represent a new strategy for Eurocastle. The combined NAV for this segment is EUR141 million, which includes investments made in the first nine months of this year in line with the new strategy, and the net corporate cash available for new investments.

 The other side is our legacy business, which combines investments in German commercial real estate and European real-estate-related debt, with combined NAV of EUR231 million. The market cap for Eurocastle as of November 8 was EUR250 million. And if you exclude the new Italian investments and the available cash, that implies EUR109 million valuation for the legacy businesses, or approximately 53% discount to legacy business NAV.

 As I mentioned earlier, we started a new investment program here, Eurocastle, which includes investments in Italian distressed loans and real-estate-related assets. But first of all, I would like to focus on the performance of the first two Italian investments that we made so far.

 On the first deal, we invested EUR14 million in May 2013. We collected so far EUR6.2 million versus EUR2.4 million estimated at underwriting for the same period, representing a 158% increase. The investment IRR compared to the underwriting has increased from 17.2% to 19.4% on the performing loan pool, and from 19.9% to over 30% on the nonperforming ones.

 On the second deal, we invested EUR2.7 million in July, and with collections so far, the investment IRR has increased from 18% at underwriting to approximately 19% now. Both investments are unlevered.

 So in order to achieve our investment objectives, we developed a strategic relationship with Italfondiario; that is the Italy's largest independent non-bank special servicer. It is also an affiliate of our manager, Fortress Investment Group. We believe that in order to succeed in investing in Italy in this asset class, it is crucial to have on-the-ground presence and partnership with a strong servicing platform that Italfondiario actually offers.

 We also intend to leverage our manager's expertise in Italy. Fortress has been active in Italy for over a decade and has a strong team of professionals with experience in sourcing investment opportunities and long-term relationships with senior management of top Italian banks.

 We believe that these factors give Eurocastle a significant competitive advantage and provide access to a wide range of investment opportunities, as well as underwriting and active servicing of the portfolios to be acquired.

 Italian NPL portfolios are, as many of you know, typically highly diversified and require active loan-by-loan underwriting and asset management. And we believe we have a top-tier team here to execute this strategy and generate very attractive risk-adjusted returns for the shareholders.

 As you can see on page 5, the current pipeline of deals that Fortress is examining is over EUR14 billion of gross book value of nonperforming loans. We are in negotiations to acquire a portion of four portfolios of NPLs with a face value of over EUR2 billion.

 For the first two portfolios, we have submitted a [filing] bid and we are waiting to hear back from the sellers. The four sellers of the portfolios have indicated to us that they wish to complete the sale by the end of December, 2013. The potential equity investment for Eurocastle on these four deals, if successfully completed, is between EUR40 million and EUR70 million. The underwriting of those portfolios has been done considering an unlevered IRR between 15% and 20% and money multiple between 1.5 and 2 times, to be totally consistent with our strategy.

 So Italy historically has been a very cyclical market, and we have not seen many NPL transactions for a long time. And this is not because there was a lack of demand for this asset class, but because the spread between bid and ask was too wide. The investors couldn't pay the book value and the banks didn't want to sell for a lower price.

 So the Bank of Italy and other European level regulators are increasing pressure on the Italian banks, and this since the fourth quarter of 2012, to increase the provision against the nonperforming loan book, thus aligning the book value of those loans to the fair market value.

 One thing that I would like to mention, that once the bad loans are correctly provisioned, it makes no sense for the banks to keep them. They are no yield, they are mass asset management intensive, and they have a high capital absorption. So once they are correctly provisioned, it is better for the banks to sell them and redeploy the capital in fresh lending.

 In addition, between February and April 2014, the IBA will start an asset quality review that can lead to additional provision on the nonperforming loan book.

 We believe that the current stock of NPLs in the Italian market grew during the last quarter from EUR136 billion to EUR140 billion. This number could be close to EUR150 billion or EUR160 billion by year-end, approximately a four times increase since 2008. We believe that after several years of inactivity, Italian banks are now entering into a third big wave of NPL sales, with the bank disposing approximately EUR50 billion of NPLs -- in the next slide -- between 2014 and 2016.

 In addition to that, we see significant opportunities to diversify the Company's investment objectives and grow our business here. In addition to NPL investments, we have identified three additional ways in which to grow the Company. We are currently evaluating direct real estate investments, mainly asset re-conversions, investment in existing Italian real estate closed-end funds that trade at significant discount to asset value, and investments in selected European debt opportunities, backed all or in part by Italian real estate.

 So I would like to give a little more background as to why we have selected to focus on these asset classes in particular. On the real estate side, the Italian government recently announced that it is getting ready to start selling its real estate assets to reduce the public debt. We think that properties for sale by the Italian government and the local authorities, together with the properties to be sold by real estate funds approaching their life end and distressed sellers, represent an interesting opportunity for us.

 We intend to use our Fortress expertise in the Italian real estate market to specifically target assets for reconversion, mainly from office to residential use. And this will generate attractive returns for Eurocastle. We are currently evaluating an investment of approximately EUR70 million to acquire four properties, targeting returns between 15% and 20%.

 If you look at page 7 of the book, this sets out our strategy for the direct real estate investments. Due to the lack of competition, we think that there is a good opportunity to invest in vacant, inefficient real estate assets in prime locations, Rome and Milan, at a discount to market value for reconversion to luxury residential units, targeting a 1.5 to 2 times return on the capital. We believe that we can acquire these kind of properties from the Italian government, local authorities, real estate funds approaching life end and distressed sellers.

 Eurocastle intends to leverage Fortress competencies in the Italian real estate market and create partnerships with local asset managers, developers, and to source, acquire and redevelop the assets to maximize the value.

 On page 8, I would like to draw your attention to the other two near-term investment opportunities that we are now considering, namely targeting investments in Italian closed-end real estate funds that trade at significant discount to asset value and European debt opportunities backed in all or in part by Italian real estate.

 Right now, there are over 370 Italian real estate funds with nearly EUR50 billion of assets under management. Of the 370 funds, 22 are listed in the Milan stock exchange and there are approximately EUR7 billion of assets under management. Those 22 funds trade at an average 50% discount to NAV as of this November 12, 2013, and many of them have very low leverage and are close to their life end.

 Lastly, it makes sense for us to lever both Fortress expertise and Eurocastle historic experience in both real estate and the bond market. As a result, we are coming to look at a number of European debt opportunities, including senior Italian NPL debt and European commercial real estate debt, which have all or in part exposure to the Italian real estate market.

 Let's turn a second to our legacy business. So Eurocastle's historical business model has been focused on investing in two different categories, German commercial real estate and European real estate-related debt. So within our real estate portfolio, over the course of the last few years, we have sold a number of assets and used proceeds to repay the debt obligations. Today, the commercial real estate portfolio consists of 391 properties across Germany with a market value of approximately EUR1.6 billion, which is equivalent to an NOI yield of approximately 5.8%. And those are held in 11 separate vehicles with no recourse financing. It is important to remember that all of the debt is no recourse to Eurocastle, and therefore is no liability for Eurocastle to fund a shortfall.

 The NAV for the real estate business is EUR172 million. Our strategy continues to be focused on deleveraging certain portfolios and, where possible, realizing the value to Eurocastle. In the first nine months of 2013, Eurocastle continued to make progress on near-term debt maturities and expanded the Drive Junior and Mars Fixed 2 facilities to January and December 2014, respectively. In addition, it is in discussion with the lenders, the representatives of the bridge loan, regarding the upcoming January 2014 maturity.

 It is important to remember also Eurocastle will be able to monetize its real estate investments through a combination of the property return in cash flows, cash flow from sales and fees. And so I would like to hand it back to Steve now, who will discuss about the debt business. Steve?

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 Steve Charlton,  Eurocastle Investment Limited - CFO   [6]
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 Thanks, Francesco. A summary of the debt business is shown on slide 10. We have EUR406 million of assets, consisting mainly of commercial real estate backed loans and securities held across three separate ring-fenced portfolios.

 At the end of September, net assets totaled EUR59 million, down approximately EUR15 million from the half-year-end. This fall was mainly due to the full impairment of two junior loan positions in CDO V for a total of EUR23.4 million.

 CDO V is a commercial real estate debt securitization vehicle with net assets of EUR28.8 million and long-term nonrecourse financing. At the period end, it owned 55 assets with a carrying value -- that is amortized costs less impairment charges -- of EUR354.3 million, and securitized debt of EUR325.5 million.

 Up until June this year, when the reinvestment period ended, we had reinvested EUR29 million in investment-grade commercial mortgage-backed securities. Since then, EUR36 million of principal proceeds have been used to repay senior debt.

 Although the collateralization tests within CDO V continue to fall significantly below the thresholds required for Eurocastle to receive returns, the long-term and nonrecourse nature of the financing enables us to actively manage the assets over time to potentially achieve the recoveries sufficient to generate some returns in the future. Presently, however, distributions from CDO V are limited to management fees, which amounted to approximately EUR200,000 for the year to date. Additional cash flows from the other two portfolios totaled EUR1 million and were mainly in the form of excess interest.

 Principal cash flows from the investments within CDO IV, which has net assets of EUR29 million, continue to be used to repay outstanding debt which matures in December next year. Following the receipt of principal repayments at and since the third quarter end, the outstanding loan balance has been further reduced by EUR16.5 million. This loan currently stands at EUR4.2 million and is expected to be fully repaid in January next year.

 The assets in this portfolio are mainly carried at market values and have performed favorably during the year, resulting in an increase in net asset value of EUR11.5 million. Of the remaining assets in this portfolio, approximately 75% comprise actively-traded or liquid CMBS.

 On behalf of everyone at Eurocastle, we thank you for your continued support and look forward to updating you in due course on our further progress during the final months of the year. With that, I would like to hand you over to the moderator for the Q&A session. Thank you.



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Questions and Answers
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Operator   [1]
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 (Operator Instructions). Jordan Celeste, EMS Capital.

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 Edmond Safra,  EMS Capital - Analyst   [2]
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 Edmond Safra, actually. How are you? I have a question about the legacy cash flowing portfolio of German real estate. Do you expect to be able to roll the debt on these portfolios, or do you think you are going to have to sell them when the debt maturity approaches?

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 Francesco Colasanti,  Fortress Investment Group LLC - Managing Director   [3]
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 Well, the portfolios -- we have several portfolios. And there are different strategies for the different portfolios. Certain portfolios have more levered assets, and so we can actually sell the assets in the open market, realizing cash flow for Eurocastle. And they are a combination of -- each portfolio has to be treated separately. We have portfolios where the debt is 3 to 5 years away from now that are generating a good cash flow for Eurocastle. And the debt is swapped. So considering the swap rate and the interest -- where the interests are now, the sale of the assets is impacted by the negative mark-to-market of the swap.

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 Edmond Safra,  EMS Capital - Analyst   [4]
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 Correct. So it's better to hold until their maturity.

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 Francesco Colasanti,  Fortress Investment Group LLC - Managing Director   [5]
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 Exactly, exactly. There are certain portfolios that produce good cash flows, that for us it is better to hold near the maturity of the debt, reduce the negative mark-to-market of the swap, and then work on the portfolio and then maximize the value then.

 There are certain other portfolios that have debt maturities that are close. And so on these portfolios, we try to sell the assets and try to recover as much cash as we can.

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 Edmond Safra,  EMS Capital - Analyst   [6]
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 Right. Okay. And what is happening to the underlying market in Germany for these types of assets in terms of demand for occupancy? Is it getting better, is it unchanged, how are you seeing that?

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 Francesco Colasanti,  Fortress Investment Group LLC - Managing Director   [7]
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 Well, the German economy had a weak start to the year, but has accelerated after the spring and the summer. The GDP in 2013 has increased 0.7%. And it's an attractive investment environment for investors. There's a pretty good demand from international investors and a lot of local investors.

 In terms of investments, commercial real estate properties in Germany register like a transaction volume of EUR18.8 billion for the first three quarters, and it is an increase of about 30%, or like EUR4.3 billion year on year. And this is the best nine months' results since 2007.

 So the investors are really focused, especially the big ones, on the five major German cities. But, given the shortage of product in those cities, they are going now outside these major cities and they are looking at portfolios of assets like the ones in our portfolios.

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 Edmond Safra,  EMS Capital - Analyst   [8]
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 Okay, understood. Now switching back to the Italian NPLs, can you -- do you have any strong feeling as to in the end whether we are able to put this cash to work this year or it is too early to tell?

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 Francesco Colasanti,  Fortress Investment Group LLC - Managing Director   [9]
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 Well, we made these two binding offers and we are preparing the other binding offers for the other two portfolios. I am confident that we will buy some of these portfolios. I cannot tell you exactly what will be the final money that will be put at work this year. But I think that there are good prospects between the four portfolios that we are looking at, and the rest of the portfolios, the pipeline that is the EUR14 billion, that we will start pushing starting from January 1, 2014.

 So we expect something like between EUR40 million and EUR70 million to be put at work in this asset class for Eurocastle by year-end, if we are able to close the deals that we have already underwritten.

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 Edmond Safra,  EMS Capital - Analyst   [10]
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 Okay, thank you.

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 Francesco Colasanti,  Fortress Investment Group LLC - Managing Director   [11]
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 You are welcome.

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Operator   [12]
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 John Britton, Select Equity.

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 John Britton,  Select Equity - Analyst   [13]
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 Hi guys. I just was wondering if we could get a little bit more characterization of the market on the Italian side. I guess were you guys surprised that you only were able to put to work EUR19 million so far? Is that consistent with what you expected? And have there been any changes -- were there any dynamics that were preventing greater velocity or greater number of transactions from occurring earlier in the year that you think are changing or are likely to be different in the fourth quarter such that you can transact considerably more, as you have indicated?

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 Francesco Colasanti,  Fortress Investment Group LLC - Managing Director   [14]
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 Thanks. So it is pretty standard in Italy that you will buy the portfolios towards the end of the year and towards the end of June. This is when banks have to make their balance sheet, so they are trying to -- they actually offload the loans from the book around this time.

 In terms of expectations, let me give you a little bit of sense of what happened during the past three months. The Bank of Italy started the third inspection in 12 months on the Italian banks and asked for additional provisions. The Italian banks are, as you can imagine, under pressure from the Bank of Italy. And they are going through this round of additional provisioning towards year-end.

 In February next year, between February and April, the EBA will start the asset quality review and will include also the provisions on the nonperforming loans. And starting from October next year, the regulator will change, and will change from the Bank of Italy to the European Central Bank. So I think that more provisions will be put in the banks' balance sheets over the next six months due to these combined factors, so EBA and the change of the regulator.

 One important reform was introduced from a tax perspective in October, and that is to be ratified by December. Before, the banks that made provisions on the loan book were able to use the tax deduction over 18 years' period. This new law allows the banks to take the tax benefit over a much shorter period of time, five years. So this creates an additional incentive for the banks to take provisions on the nonperforming loan book.

 So those are the events in terms of high level, I would say.

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 John Britton,  Select Equity - Analyst   [15]
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 Okay, that's helpful.

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 Francesco Colasanti,  Fortress Investment Group LLC - Managing Director   [16]
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 Yes. But in terms of deals, what we think is that the current pipeline, we think is -- the current deals that we have either under exclusivity -- formal exclusivity or we have totally underwritten are four good deals. And what we are targeting right now are really good deals, where we can make like 15% to 20% IRR, and we want to be consistent with this strategy. So we think that we were able to -- on these four portfolios to reach this level, and so that is why we want to invest.

 We looked at other portfolios, but at lower IRR and we didn't like it. We think this is the fair price. These portfolios are all cherry-picked, so I think we like what we are bidding right now and we really want to make good 15% to 20% IRR with conservative assumptions. I think that -- and invest the capital in the right way.

 So I think that sticking with this concept of investing capital in the right way, so not taking risks, not too much risk, I will say, or risk-adjusted 15% to 20% we like, we think that between the end of this year and the beginning of next year, and I would say the first six months of next year, we'll deploy significant capital in the NPL business.

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 John Britton,  Select Equity - Analyst   [17]
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 Okay, thank you.

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 Francesco Colasanti,  Fortress Investment Group LLC - Managing Director   [18]
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 You're welcome.

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Operator   [19]
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 (inaudible), [Kampen].

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Unidentified Participant   [20]
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 Hello, good afternoon, gentlemen. I have basically a little bit the same question as the first gentleman in the call, looking at the legacy portfolio in Germany. It is basically tying up the majority of the equity, the NFE within the Company. How do you expect to extract that, especially looking at the Drive portfolio, which has the majority of the equity in the real estate business in Germany, EUR53 million? Technically, if you look basically at it, it is a bankrupt portfolio, with 90% LTV and only 58% occupancy.

 Would it be another possibility to basically sell this portfolio or basically the whole legacy position in Germany to another private equity player, even if you need to take a 50% haircut, and fully continue on the Italian portfolio?

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 Francesco Colasanti,  Fortress Investment Group LLC - Managing Director   [21]
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 Well, I would say -- as I mentioned during the presentation before, there are three ways to make money in the existing real estate portfolios. The first is to get the levered cash flow for the ones that produce cash flow. The second thing is extracting as much equity as we can through the sales -- so sales cash flow. And the third thing is our fees, that is -- Eurocastle actually charges on these portfolios.

 So the different portfolios; the portfolios that are more levered or more challenging in any case generate lot of cash flow through one of the three of the previous components that I mentioned to you.

 So if you think about selling the Drive portfolio to a private equity firm, it will be difficult, I would say. I think that we know the portfolio very well. We accomplish many good results. It is overlevered, and there is not much we can do about it. We can say this is a ring-fenced portfolio, so we are not responsible if there is a shortfall. We generate a good amount of fees. And we think that by managing this portfolio ourself we have the best chance to recover our money -- or as much as we can.

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Unidentified Participant   [22]
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 Yes, okay. But just looking at the share price, of course, which has been pretty stable, and, as you mention on slide 3, indeed, a pretty heavy discount to NAV. But yet if you look at the discounted gross asset value, it is actually pretty minimal. And I am afraid a bit that going forward, the Company will trade at substantial discounts if you continue of course with this German portfolio, and despite of course the fees coming in.

 And then I think we all agree there is more upside in the Italian market with opportunities than in the German portfolio. (multiple speakers)

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 Francesco Colasanti,  Fortress Investment Group LLC - Managing Director   [23]
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 I think that is right. And I think that what we need to do is keep working as we are doing right now to generate as much cash as possible from the legacy business, especially the real estate portfolios. There are a number of portfolios that are pretty attractive and are pretty good portfolios and that generate considerable levered cash flow. And we need to focus on the new strategy, because that is the future of Eurocastle.

 And this is what we think we need to -- we had very good results on the first two investments. They are small, but we wanted to do great deals. And that is the path of Eurocastle, investing in something different that we want to have our investors very happy for what we are doing on the new business side.

 And we will do our best to recover as much as we can, as hard as we can, on the German real estate portfolio.

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Unidentified Participant   [24]
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 All right. Thank you very much.

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 Francesco Colasanti,  Fortress Investment Group LLC - Managing Director   [25]
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 You're welcome.

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Operator   [26]
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 At this time, I will now turn the conference back over to Mr. Andrew Dempsey for closing remarks.

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 Andrew Dempsey,  Fortress Investment Group LLC - Managing Director   [27]
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 Thank you, everyone, for attending the third-quarter 2013 earnings call for Eurocastle. Please feel free to reach out to us with any further questions, comments or concerns, and we look forward to updating you as the year unfolds. Thank you.

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Operator   [28]
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 Thank you. That concludes today's conference call. You may now disconnect.






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