The problems in the US commercial real estate market, which have already hit banks in New York and Japan, have begun to spill over into Europe, raising fears of wider contagion.
The aggressive rise in interest rates has led many financial institutions to now receive increasing provisions for debt that mainly concerns property owners and builders. A recent statement by US Treasury Secretary Janet Yellen is indicative, who argued that losses in commercial real estate are a concern that will put significant pressure on owners.
The common denominator in all these developments is that banks have lent to real estate development companies that are being hit by the problems of the economy and especially by office spaces that remain empty in the post-pandemic period. This lower demand also lowers the prices of commercial real estate which is a guarantee for the granting of loans.
The bomb in the foundations
And European banks have about €1.4 trillion in loans to the struggling commercial real estate sector.
Germany’s banks have been in the spotlight as the country finds itself in its worst real estate slump in decades, marked by insolvencies, stalled construction and freezes on real estate deals.
The fallout from the recession is likely to hit banks in France and the Netherlands, which are among Europe’s biggest commercial real estate lenders.
Fall in prices
As Reuters writes in its analysis, in Germany, Europe’s largest economy, commercial real estate prices fell by 10.2% in 2023, according to the VDP banking association. The declines were similar on average across the euro area, according to European Central Bank data.
The real estate sector accounted for about a fifth of Germany’s output.
But higher interest rates and rising construction costs have driven some developers into insolvency as bank financing dries up, deals freeze and prices fall.
In the United States, higher interest rates, refinancing difficulties and lower office occupancy have hit the commercial real estate sector hard, fueling fears of a global recession.
Industry experts say prices need to fall further. There is currently not much price transparency as owners are unwilling to sell at discounted prices and asset managers are slow to re-evaluate their holdings.
“Valuations are still very high. Everyone knows it,” says Alexandre Grellier, founder of Drooms, a service provider to real estate agents.
How badly banks are affected depends on the scale of the market downturn. Many real estate companies in Germany, for example, hope for a recovery by the middle of this year, while other executives predict a worsening of the path through 2025.
Which German banks are most exposed?
With 285 billion euros in commercial real estate loans, German lenders account for about a fifth of EU banks’ 1.4 trillion euros in loans to the sector, according to data from the European Banking Authority.
Among German banks, Deutsche Bank, the country’s largest, has the most outstanding loans in the sector, followed by two state-backed Landesbanken.
Deutsche earlier this month disclosed 17 billion euros in loans to the hard-hit US commercial real estate market. That would make up about a fifth of the 76 billion euros that EU banks have lent to the United States in total, based on EBA figures.
What is happening with the Pfandbriefbank
Deutsche Pfandbriefbank (PBB), created after the global financial crisis more than a decade ago, is one of Germany’s leading real estate financiers.
It has 5 billion euros – or 15% of its loans – committed to the US commercial market, it said.
Last week, it doubled risk forecasts and investors spooked, dumping its stocks and bonds. PBB reacted by issuing two separate announcements trying to reassure the public.
Late Wednesday, credit rating agency S&P downgraded PBB because of its ties to commercial real estate and gave it a negative outlook.
Most EU banks have no direct exposure to US commercial real estate, with the exception of German banks, credit rating agency Moody’s said in a report on Wednesday.
Elsewhere in Europe
Some European banks are even more exposed to commercial real estate lending than German banks, with France and the Netherlands dominating, according to EBA data. Rabobank and BNP Paribas top the table.
Loans from French banks in the sector are slightly ahead of Germany, according to EBA data, with the Netherlands coming in third, ahead of Italy and Spain.
What is the perspective?
Experts say the outlook is bleak, although a rate cut later this year could provide some relief, and not all European property markets are in as bad shape as Germany.
“A reversal in property prices is not yet in sight, despite frequent speculation. The situation will remain difficult for now in 2024,” says VDP CEO Jens Tolckmitt.
The ECB warned in November that the housing downturn could last for years, although it said the sector was not large enough to pose a systemic risk to lenders.
The International Monetary Fund said smaller and regional banks, particularly in the US, as well as non-bank financial intermediaries with high exposure to real estate, could face challenges.
Last month, the head of Germany’s financial regulator stepped up its warnings, predicting that 2024 will be less rosy for bank profits and that real estate is a growing risk.
Warning signs
The plunge in German bank bonds was the latest in a series of warning signs. New York Community Bancorp was downgraded to junk by Moody’s Investors Service after highlighting real estate problems, while Japan’s Aozora Bank posted its first loss in 15 years on provisions for loans made to US commercial real estate.
“There are serious concerns in the US CRE market,” said Rabobank strategist Paul van der Westhuizen. “It’s not an issue for the biggest US and European banks, but the smaller property-focused German banks are already feeling the effects. But right now it’s more a question of profitability than a question of solvency for them. They have adequate capital and are less exposed to the threat of deposits than pure retail banks.”
In its results Deutsche Bank AG recorded provisions for losses on commercial real estate in the US, which were four times larger than last year. He warned that refinancing was the biggest risk to the troubled sector as asset values suffered.
Loan write-offs
Elsewhere in Europe, Switzerland’s Julius Baer Group Ltd. said it would write off huge loans to bankrupt real estate firm Signa. While it was a specific issue, it added to wider concerns about how far things could spread.
Last week, Morgan Stanley made calls to clients recommending that they sell Deutsche PBB bonds. Bonds maturing in 2027 rose more than 5 cents after that to 97, according to CBBT data compiled by Bloomberg. Meanwhile, the bank’s AT1 notes fell as much as 15 cents to 36 between Tuesday and Wednesday.
Deutsche PBB said that while it raised loan loss provisions to 210-215 million euros for the full year, it “remains profitable thanks to its financial strength.”
Sonja Forster, vice president of European Financial Institutions rating at Morningstar DBRS, said “PBB’s focus on prime locations and relatively conservative LTVs provide some downside protection.”
“However, given that refinancing risk is still high and new equity available to borrowers is limited, we are monitoring the situation very closely,” he told Fortune.
Bafin, the country’s German banking regulator, said it was monitoring the situation, declining to comment on specific lenders.
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