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The European Central Bank has warned that euro zone property companies are suffering sharply increased losses and some will struggle to repay debts that have risen to levels higher than before the 2008 financial crisis.
The ECB said the losses “will affect the resilience of banks' lending books”, blaming them on a sharp rise in funding costs, falling commercial property values, falling rental income and growing concerns about the energy efficiency of buildings.
The central bank said signs of stress in the commercial real estate sector, which accounts for 10% of total euro zone bank lending, “could significantly amplify adverse scenarios” and “result in significant losses” across the financial system.
As part of its twice-yearly financial stability review, the European Central Bank (ECB) said the average debt of Europe's largest real estate companies is more than 10 times its profits and is “close to or above pre-global financial crisis levels.” The full review will be published on Wednesday, but the ECB announced its concerns about commercial real estate a day early.
The ECB's interest rate hikes have hit the industry hard. Eurozone credit registry data shows that financing for the purchase of European commercial real estate assets is 2.6 percentage points higher than it was before interest rates began rising last year. The central bank's benchmark deposit rate is now 4 percent, up from minus 0.5 percent before the tightening cycle began.
The ECB said rising borrowing costs would create refinancing challenges for highly indebted companies, pointing out that ratings agency Moody's had downgraded the ratings or outlook for 40% of European property companies in the year to March 2023.
The problem is most acute in countries such as Finland, Ireland, Greece and the Baltic states, where more than 90% of loans to commercial real estate companies are on floating interest rates or due within the next two years, compared to just 30% in the Netherlands and 40% in Germany.
“Business models established on pre-pandemic profitability and a prolonged period of low interest rates may not be viable in the medium term,” the ECB warned.
The sharp decline in the eurozone commercial real estate market is also evident from the 47% drop in the number of transactions in the sector in the first half of this year compared to the same period in 2022.
The ECB expects the share of bank lending to loss-making property borrowers to double to 26 percent, but warned that this could rise to half of all lending if industry sales fall by a fifth and tougher lending conditions continue for another two years.
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The central bank said debt levels “may deteriorate further” as these companies' profits fall and commercial property prices adjust downwards.
The shift to working from home and online retail has hit demand for office and retail space, squeezing rental income for property owners, while older, lower-quality buildings have seen rents fall sharply as occupiers prioritize energy efficiency in their buildings.
In a sign that investors think commercial property prices have fallen sharply over the past two years, the market capitalization of listed property companies in the euro zone has fallen from 110% of the book value of their assets to less than 70%.
The European residential real estate sector faces similar challenges, but the ECB said a strong labor market was keeping mortgage default rates low, while a housing shortage and rising construction costs were supporting prices.