Funding gap of €90bn weighing on German banks

Investor activity is likely to get a boost from the recent fall in inflation and in borrowing costs, but the ongoing threat is the existing capital gap in the refinancing of old loans, says a research note from AEW Capital Management in its February update.

Inflation in the eurozone has fallen faster than expected and prime yields are back up again above the cost of debt. Borrowing has become more affordable, and demand for property loans should increase accordingly. AEW forecasts that eurozone swap rates, which are currently at just under 3%, could fall to just over 2% by the end of 2025, which would imply borrowing costs at around 3.5%.

Challenges in refinancing old loans

But all this won't go far in closing the gap on existing financing deals that were closed with too little equity. The AEW figures show that around 16% of the commercial property loans concluded in the 20 largest European markets between 2018 and 2021 are likely to run into refinancing difficulties, which corresponds to a capital gap of around €90 billion.

However, this is distributed very differently across individual asset classes, and not all hard-to-refinance loans are expected to trigger a default or a loss for the lender. The gap is largest for retail property at 23% of the financing volume, followed by offices at 20%. In the logistics segment, the gap is only 5% of the financed loan volume.

AEW classifies around 7.5% of the €572 billion 2018-21 CRE loan originations to be at risk of default. It estimates the losses to be shouldered by the lenders at one third of this, i.e. 2.5% of the total amount. These estimated losses are in line with historical European CMBS loan losses post-GFC, says AEW.

Here too, however, individual asset classes and countries are overrepresented: AEW expects credit losses of 11% for retail property and 4.5% for Germany as a whole, i.e. almost twice the European average.

One of the reasons for this is that in the final phase of the property boom in Germany, lenders accepted higher loan-to-value ratios in some cases than in other European countries, such as Finland, Ireland or Italy. AEW points out that these estimates are subject to a certain degree of uncertainty, as shifts in market values are not always reflected promptly in the banks' loan portfolios due to delayed valuations.

Little systemic risks to the banks

Hefty though these losses will be, AEW sees little systemic risk to the banks. The banks are better capitalised than at the time of the major financial crisis in 2008. Despite strong growth in the years before the interest rate turnaround, the share of property loans in the total loan book of European banks was only around 7% at the end of 2022 (in Germany: 10%). The share of property financing in non-performing loans was around 4% on the same reporting date. "Both the low proportion of non-performing loans and the high coverage ratios generally give European banks little cause for concern," write the analysts.

This also applies in principle to Germany, where riskier tranches were often not underwritten by banks but by alternative financiers such as insurers and specialised debt funds.

The German financial watchdog BaFin also recently expressed confidence in the health of the German banks. Adam Ketessidis, director general for risk analysis, macro-prudential supervision, and crisis management, said in a recent media interview: “We started several years ago to encourage banks to increase provisions in real estate, especially commercial real estate, and we are in close contact with the auditors about that. We do not see commercial real estate as a risk to the financial system as a whole, so far. We think it will face more challengers than other asset classes, but it’s not a systemic crisis.”

Creditreform Rating gives German banks rating of 'resilient'

A new report issued this week by Creditreform Rating on the commmercial property risks of German banks concluded cautiously that capitalisation is solid and non-performing loan ratios are moderate by European standards. But a further deterioration in the credit quality of the banks' customers is to be expected.

Johannes Kühner, Principal Analyst at Creditreform Rating and the author of the report, says that German banks active in CRE lending have so far proved to be largely resistant to the deteriorating market conditions. This is largely due to the strong interest rate-related boosts to their other business areas, which are compensating for higher loan-loss provisions in their property lending. The heaviest losses are being faced by specialist lenders to US property, such as pbb Deutsche Pfandbriefbank and Aareal Bank, which have recently taken heavy write-downs and massively increased their risk provisioning.

The study also highlights how the level of non-performing loans (NPLs) in the CRE industry has remained remarkably manageable so far, despite the wave of insolvencies afflicting the market. (Of course, as we discuss elsewhere in this issue, this has probably to do with German traditions in respect of facing up speedily to losses, for political and other reasons.)

German banks have proved traditionally unwilling to aggressively write down bad loans and sell them off, tending to sit on them for longer than other countries while they perform internal workouts. This means less new lending and a slower, more painful recovery of the market.

Philipp Beckmann, Head of Financial Institutions at Creditreform, puts a positive spin on his agency's market view. "We are at a very low NPL level overall in Germany compared to the rest of the EU. In our experience, the senior tranches in the banks' commercial property financing were also provided with ample risk buffers in the past. With regard to ongoing price corrections on the CRE market, we do not see any acute pressure to act with regard to the ratings of the German banks that receive a credit rating from us."