Germany's commercial real estate crisis could mean trouble for the country's banks due to their high exposure to the sector.
ADVERTISEMENTEurope's rapidly deteriorating commercial real estate crisis could potentially impact its banks as well.
Back in July 2023, European banks had about €1.4 trillion tied up in loans to the commercial property sector, according to the European Banking Authority (EBA).
Germany has been particularly hit, especially due to the country currently dealing with the deepest real-estate crisis in several years. This is mainly due to increased property developers seeing higher costs of borrowing, following soaring interest rates.
This in turn has led to more developers facing bankruptcies, as well as several commercial and residential projects being abandoned or postponed. Although the German real estate sector still has a considerable number of back orders, new orders have been relatively slow to come in, causing the industry to slow down further.
Refinancing woes and decreasing office vacancies, as remote working continues for several employees, also contributed to this dampened sentiment. According to Combine Consulting, German office occupancy fell to about 40% in July 2023, from approximately 61% pre-pandemic.
Apart from the European commercial real estate sector, several major German banks are also considerably vulnerable to changes in the US real estate sector, which has also been going through a downturn.
As a result, investors have already started reducing their stakes in certain banks such as Deutsche Pfandbriefbank, due to these rising concerns.
German consumers could also be dealing with a "double whammy" of rising interest rates and falling collateral values, according to Jackie Bowie, managing partner and head of EMEA at Chatham Financial.
"So what we’ve seen in the last two years is a lot of borrowers extending their loans out by just a short time, maybe two years," she said. "This was in the expectation that either asset values would stabilise, that they would be able to sell assets and deliver, or the interest rates would come back down and they could refinance at a cheaper rate.
"So obviously market rates have started coming back down," Bowie added. "While central banks haven't moved yet, there still seems to be a little bit of a reckoning that is to happen around the realisation that asset values have probably got a little bit more to fall."
How have banks been protecting themselves against the risk?
Bowie highlights that although the risk commercial real estate presents to German banks is grim, it's not as bad as during the global financial crisis of 2008-2009. Back then, banks had not made enough provisions for the risks of exposure, such as falling property prices. This in turn meant that in the event of falling collateral valuations, banks took a major hit.
However, in the past few years, banks have taken significant measures in making provisions, as well as reducing their loan-to-value ratios.
"I don't know what the average would be, but it wasn't unusual to have loan-to-values of 75% or 80%, while today, it’s more like 55%," Bowie said. "So even if asset values have still got a bit to go, there's more gap with regard to the bank's ability to recover that debt, due to the value of the asset.”
As such, due to these higher provisions, it is very unlikely that many banks may need bailouts, in the event of a commercial real estate crash. However, in the US, several smaller regional banks may consolidate amongst themselves, or be taken over by larger rivals, for more strength.
Furthermore, banks have also been reducing the value of commercial real estate in their portfolios. Rising bank profits in the last few months have also provided an extra safety net, in case of any losses arising from this real estate crisis.
The European Banking Authority's December 2023 Risk Assessment Report said: "An increasing number of banks appear reluctant to increase commercial real estate (CRE) and other corporate lending going forward. The slowdown in lending could create a negative feedback loop on economic growth dynamics.
"Concerns around real estate markets are also manifested in banks' rising provisioning against real estate exposures. The EU banking sector's global footprint makes it vulnerable to geopolitical risks as well as idiosyncratic developments in certain markets, such as US CRE exposures."
The European Banking Supervision also recently strengthened existing measures of reducing banks' vulnerability to commercial real estate. These include two core measures, one being a CRE targeted review and the other being a CRE on-site inspection campaign.
ADVERTISEMENTThe CRE on-site inspection essentially deals with all CRE portfolios, as well as collateral valuation and credit risk management, and involves on-site supervision of bank practices for up to 3 months.
The CRE targeted review looks at developing risks in banks’ domestic commercial real estate portfolios, through a credit risk management lens. It also employs peer benchmarking in order to better evaluate risk management factors.
In the US, following the global financial crisis, banks have also had to periodically look at their entire credit exposure, including commercial real estate. If some loans look like they may not be paid back, banks have had to put away provisions to cover potential losses, in small measures.
This goes a long way in ensuring that there are no sudden, large losses which might potentially affect a bank’s liquidity and long-term viability, as most CRE losses would already have been provided for earlier.
What is the outlook for the German commercial real estate sector?
Coming to the outlook for the German commercial real estate sector this year, Bowie expects the gap between buyers and sellers to start closing more. This will be mostly due to sellers being forced to refinance by lenders, once their short-term loan extensions are almost over. Hence, they may not be able to sell their properties for the price they were expecting.
ADVERTISEMENTOn the other hand, Bowie believes buyers are also likely to become a lot more realistic about the kind of properties they are able to comfortably afford, thus helping close the gap on their end as well. This is particularly expected to be seen for assets which don’t have very robust income-generating fundamentals.
The Knight Frank European Real Estate Outlook 2024 said, regarding Germany: "In the office sector, we continue to see rising prime rents driven by demand for high quality and ESG-compliant space.
"At the same time however, vacancies are increasing and take up is at levels last seen in 2013/2014, as a delayed response to the recession. Many companies will continue to postpone signing new leases and prefer opting to extend contracts.
"The strong project pipelines are somewhat hampered by construction and planning delays. Additional space has come to the market as occupiers reduce their space requirements partly as a result of increased working from home. But office vacancy rates remain low in an international context."
What other risks could Europe see in the near future?
Apart from the commercial real estate situation, Germany has also been seeing an increasing number of strikes in the airline industry, especially impacting the national carrier Lufthansa, as well as farming protests in several parts of the country.
ADVERTISEMENTEurope as a whole, also faces increasing risks in the automobile sector, due to an influx of cheaper Chinese-made vehicles, especially electric vehicles. This has severely undercut the competitiveness of European-made vehicles.
Furthermore, the continent also continues to face energy risks arising from the Russia-Ukraine war, amid fluctuating energy imports from Russia. More recently, the Israel-Palestine war threatens to increase energy prices once more.
The ongoing Red Sea Houthi attacks have also led to considerable delays in shipments to Europe, as well as the unavailability of several products in supermarkets, while others have seen prices rise.
Bowie said: "I think to be honest, it’s mainly around the overall economic situation. The European economy is exceptionally weak, led by Germany, of course, because it’s the weakest. It's a heavy industrial economy. It's very export-led. And yet, domestic demand is weak."
The overall economy is not in great shape at all, according to Bowie. She said that the main issue regarding the real estate situation is asset valuations.
ADVERTISEMENT"Occupancy demand and rental income is still good," she said. "But if the economy continues to be this weak and in fact, goes into recession, then you'll start to see pressure on the occupancy demand, tenants going bust, things like that.
"So that would be the bigger risk, that it's all going to be driven by what happens with growth in the economy, which will then be driven by how quickly the ECB can cut interest rates and try and stimulate growth," Bowie added.
The European Central Bank has maintained that it will be taking a data-driven approach to interest rates and will be awaiting more conclusive proof of slowing inflation, before taking any decisive monetary loosening steps.
