Germany's commercial real estate crisis could pose problems for the country's banks, which have heavy exposure to the sector.
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The rapidly worsening commercial real estate crisis in Europe could also have an impact on European banks.
As of July 2023, European banks had committed around €1.4 trillion to lending to the commercial real estate sector, according to the European Banking Authority (EBA).
Germany has been particularly hard hit and is currently facing its most severe real estate crisis in years, mainly as more property developers experience rising borrowing costs as interest rates soar.
As a result, more developers are facing bankruptcy and several commercial and residential projects have been canceled or postponed. Although the German real estate industry still has a significant backorder, the inflow of new orders is relatively slow, causing a further slowdown in the industry.
Refinancing worries and reduced office space availability as many employees continue to work remotely are also dampening the sentiment: Office occupancy rates in Germany fell from about 61% before the pandemic to about 40% in July 2023, according to Combine Consulting.
Beyond the European commercial real estate sector, several large German banks are also highly vulnerable to changes in the similarly struggling U.S. real estate sector.
As a result, investors have already started reducing stakes in certain banks, such as Deutsche Pfandbriefbank, due to these growing concerns.
German consumers could also face a “double whammy” of rising interest rates and falling collateral values, according to Jackie Bowie, managing partner and head of EMEA at Chatham Financial.
“In the past two years, we've seen a lot of borrowers extend their loans for short periods, just a couple of years,” she said. “This was in the hope that property values would stabilise and they'd be able to sell the property and pay it off, or interest rates would fall again and they'd be able to refinance at a lower rate.”
“Obviously market interest rates are starting to come down,” Bowie added. “Central banks haven't acted yet, but we're going to see a gradual liquidation now with the understanding that asset values are probably going to fall a bit more.”
How have banks protected themselves against risk?
Bowie stresses that the risks posed by commercial real estate to German banks are serious, but not as bad as those during the 2008-2009 global financial crisis, when banks were less prepared for risks such as falling property prices, meaning they would be hit hard if collateral values fell.
However, over the past few years, banks have taken important steps, including increasing provisions and reducing loan-to-value ratios.
“I don't know what the average is, but it used to be common to have loan-to-value ratios of 75% or 80% and now it's more like 55%,” Bowie said. “So even though asset values are still down a little bit, there's more of a gap in banks' ability to collect on debt because of asset values.”
Therefore, because of these high reserves, it is highly unlikely that many banks would need bailouts if commercial real estate were to collapse. However, in the U.S., some small regional banks may merge with each other or be acquired by larger rivals to become stronger.
Additionally, banks are also writing down the value of commercial real estate in their portfolios. The increased profits of banks over the past few months also provide them with an additional safety net in case losses arise from this real estate crisis.
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“An increasing number of banks appear reluctant to increase lending to commercial real estate (CRE) and other businesses in the coming years. A slowdown in lending could create a negative feedback loop for economic growth dynamics,” the European Banking Authority's December 2023 risk assessment report said.
“Concerns around the real estate market are also reflected in rising provisions by banks against their real estate exposures. The EU banking sector's global reach makes it vulnerable to geopolitical risks and idiosyncratic developments in certain markets, such as US CRE exposures.”
The European Banking Authority has also recently strengthened existing measures to reduce banks’ vulnerabilities to commercial real estate, including two core measures: a targeted review of CREs and an on-site inspection campaign of CREs.
The CRE on-site inspection essentially deals with the entire CRE portfolio, collateral valuation, credit risk management and involves on-site monitoring of bank operations for a period of up to three months.
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The CRE-focused review examines risk evolution in banks' domestic commercial real estate portfolios from a credit risk management perspective and also employs peer benchmarking to better assess risk management factors.
In the United States, the global financial crisis has forced banks to periodically review their entire credit exposure, including commercial real estate, and they have had to build up reserves bit by bit to cover potential losses if some loans might not be repaid.
This ensures that most of the CRE losses have already been provisioned for earlier, so there are no sudden large losses that could potentially impact the bank’s liquidity and long-term viability.
What is the outlook for the German commercial real estate sector?
As for the outlook for Germany's commercial real estate sector this year, Bowie expects the gap between buyers and sellers to start narrowing further, mainly because short-term loan extensions are almost over, forcing sellers to refinance with their lenders, which may mean they are unable to sell their properties at the prices they had hoped for.
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Meanwhile, Bowie believes the gap will narrow as buyers become more realistic about the type of property they are comfortable buying, especially for assets with less solid fundamentals for generating income.
Knight Frank’s European Real Estate Outlook 2024 states for Germany: “In the office sector, prime rents continue to rise due to demand for high-quality, ESG-compliant space.
“However, at the same time, vacancies are rising and occupancy rates have fallen to levels not seen since 2013/2014 due to a delayed response to the economic downturn. Many businesses will continue to postpone signing new leases and opt to extend their leases.”
“The strong project pipeline is somewhat hampered by construction and planning delays. Additional space is coming onto the market as occupiers have reduced their space requirements as a result of increased remote working. However, office vacancy rates remain low by international standards.”
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What other risks do you see for Europe in the near future?
Beyond the situation in commercial real estate, Germany is also seeing an increase in strikes in the aviation industry, particularly affecting national carrier Lufthansa, as well as agricultural protests in several parts of the country.
Across Europe, the automotive sector is also at increased risk from the influx of cheap Chinese-made cars, especially electric vehicles, which are making European-made cars significantly less competitive.
Additionally, the continent continues to face energy risks stemming from the Russia-Ukraine war, with energy imports from Russia fluctuating, and more recently, the Israeli-Palestinian war, which could lead to renewed increases in energy prices.
Ongoing Houthi attacks in the Red Sea have caused significant delays to shipments to Europe and led to the availability of some products in supermarkets and increased prices of others.
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“To be honest, it's mainly due to the overall economic situation. The European economy is exceptionally weak and of course Germany is leading the way because it's the weakest. Europe is a heavy industrial economy, it's export-led. But domestic demand is weak,” Bowie said.
The overall economy is not doing well, according to Bowie, and the main issue with the real estate situation is property valuations, she said.
“Occupancy demand and rental income remain strong,” she said, “but if the economy continues to weaken and actually falls into a recession, we will start to see pressures on occupancy demand, tenant bankruptcies, etc.”
“So that's going to be the bigger risk. It's all going to depend on how economic growth goes, and that's going to depend on how quickly the ECB can cut interest rates and stimulate growth,” Bowie added.
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The European Central Bank has insisted it will take a data-driven approach on interest rates and wait for more conclusive evidence of slowing inflation before taking decisive monetary easing measures.