The crisis in Germany’s commercial real estate market could spell trouble for the country’s banks, given their significant exposure to this sector.
Europe’s swiftly deteriorating commercial real estate crisis has the potential to affect its banks significantly. As of July 2023, European banks had approximately €1.4 trillion invested in loans to the commercial property sector, as reported by the European Banking Authority (EBA).
Germany has borne a particularly heavy blow, grappling with one of its most severe real estate crises in several years. This crisis has been exacerbated by heightened borrowing costs for property developers, attributable to soaring interest rates.
The repercussions have been extensive, with more developers facing bankruptcies and numerous commercial and residential projects either abandoned or delayed. Despite the German real estate sector still having a significant backlog of orders, the influx of new orders has been sluggish, further stalling industry progress.
Challenges with refinancing and dwindling office occupancy rates, stemming from the ongoing prevalence of remote work, have also contributed to this subdued atmosphere. According to Combine Consulting, German office occupancy plummeted to approximately 40% in July 2023, down from around 61% before the pandemic.
In addition to the European commercial real estate sector, several major German banks are significantly exposed to fluctuations in the US real estate market, which has also experienced a downturn. Consequently, investors have begun divesting from certain banks such as Deutsche Pfandbriefbank, driven by mounting concerns.
German consumers may also face a “double whammy” effect, contending with both rising interest rates and declining collateral values, as noted by Jackie Bowie, Managing Partner and Head of EMEA at Chatham Financial.
“So what we’ve witnessed in the past two years is many borrowers opting to extend their loans for a short duration, typically around two years,” she explained. “This decision was based on the anticipation that either asset values would stabilize, enabling them to sell assets and fulfill obligations, or that interest rates would decrease, allowing for refinancing at a lower rate.
“Currently, market rates have begun to decline,” Bowie continued. “Although central banks have not yet adjusted their policies, there appears to be an impending realization that asset values may still have further to decline.”
Banks have implemented various strategies to mitigate the risks associated with commercial real estate.
Bowie underscores that while the risk posed by commercial real estate to German banks is concerning, it’s not as severe as during the global financial crisis of 2008-2009. At that time, banks had failed to adequately provision for exposure risks, such as declining property values. Consequently, when collateral valuations plummeted, banks suffered significant losses.
However, in recent years, banks have taken substantial measures to make provisions and reduce their loan-to-value ratios.
“I don’t have the exact average figure, but it wasn’t uncommon to see loan-to-values of 75% or 80% back then, whereas today, it’s more around 55%,” Bowie remarked. “So even if asset values still have room to decline, there’s a larger buffer for banks to recover the debt owing to the asset’s value.”
As a result of these increased provisions, it’s highly improbable that many banks will require bailouts in the event of a commercial real estate downturn. However, in the US, smaller regional banks may opt for consolidation or be acquired by larger counterparts to bolster their strength.
Moreover, banks have been reducing the valuation of commercial real estate assets in their portfolios. Additionally, the recent surge in bank profits has provided an additional safety net to offset any losses stemming from the real estate crisis.
The European Banking Authority’s December 2023 Risk Assessment Report noted: “An increasing number of banks appear hesitant to expand commercial real estate (CRE) and other corporate lending in the future. This slowdown in lending could create a negative feedback loop on economic growth dynamics.”
Concerns surrounding real estate markets are also evident in the increasing provisioning against real estate exposures by banks. The EU banking sector’s global presence renders it susceptible to geopolitical risks and specific developments in certain markets, such as US commercial real estate exposures.
European Banking Supervision has recently bolstered existing measures aimed at reducing banks’ vulnerability to commercial real estate. These measures include two core initiatives: a Commercial Real Estate (CRE) targeted review and a CRE on-site inspection campaign.
The CRE on-site inspection encompasses all CRE portfolios, collateral valuation, and credit risk management, involving on-site supervision of bank practices for up to three months.
The CRE targeted review focuses on emerging risks in banks’ domestic commercial real estate portfolios, assessing them through a credit risk management lens and utilizing peer benchmarking to enhance risk management assessment.
In the US, following the global financial crisis, banks have regularly assessed their entire credit exposure, including commercial real estate. Provisions have been set aside to cover potential losses for loans deemed unlikely to be repaid, albeit in smaller increments. This proactive approach minimizes the likelihood of sudden, significant losses that could impact a bank’s liquidity and long-term viability, as most CRE losses would have already been provisioned for earlier.
As for the outlook of the German commercial real estate sector this year, Bowie anticipates the gap between buyers and sellers to narrow further. Sellers may face pressure to refinance from lenders once their short-term loan extensions expire, potentially leading them to accept lower sale prices than initially expected.
Conversely, buyers are expected to adopt a more realistic approach regarding the properties they can afford comfortably, particularly for assets lacking robust income-generating fundamentals. This adjustment in buyer expectations is likely to contribute to closing the gap between buyers and sellers in the market.
The Knight Frank European Real Estate Outlook 2024 sheds light on the German office sector, noting a rise in prime rents propelled by demand for high-quality and ESG-compliant spaces. However, vacancies are increasing, and take-up levels resemble those seen during the recession in 2013/2014. Many companies are postponing new lease signings and opting to extend existing contracts. Construction and planning delays are affecting project pipelines, while occupiers are reducing space requirements, partly due to increased remote work. Despite this, office vacancy rates remain low in an international context.
Aside from the commercial real estate situation, Germany is witnessing a surge in strikes in the airline industry, particularly affecting Lufthansa, the national carrier, and farming protests across the country.
Europe faces additional risks in the automobile sector due to the influx of cheaper Chinese-made electric vehicles, undermining the competitiveness of European-made vehicles.
Moreover, the continent confronts energy risks stemming from the Russia-Ukraine conflict, with fluctuating energy imports from Russia. The recent Israel-Palestine conflict threatens to escalate energy prices further. Red Sea Houthi attacks have caused significant shipment delays to Europe and shortages in supermarkets, leading to price hikes.
Bowie highlights the overarching economic situation as a primary concern, with Germany’s heavy industrial and export-oriented economy being particularly vulnerable. Weak domestic demand exacerbates the economic challenges.
The main risk regarding the real estate situation lies in asset valuations. While occupancy demand and rental income remain strong, a weak economy or recession could lead to pressures on occupancy demand and tenant bankruptcies.
Ultimately, the trajectory of the European economy, influenced by factors such as the European Central Bank’s monetary policy and inflation trends, will significantly impact the real estate landscape. The ECB is expected to adopt a data-driven approach to interest rates, awaiting conclusive evidence of slowing inflation before considering monetary easing measures.
