seventyfourimages/Envato
The European commercial real estate sector is bracing for further turbulence as the volume of non-performing loans (NPLs) inevitably grows. Recent interest rate cuts by the European Central Bank (ECB) may have provided a glimmer of hope, but the underlying issues remain pervasive, and could yet turn into a full-blown crisis.
Construction costs are soaring, transactions are dwindling, and the achievable purchase price factors have plummeted. The market, once buoyed by factors above 20, now sees values between 10 and 15 even for highly marketable properties.
Oliver Platt, managing partner at Arcida Advisors, highlighted in a recent commentary the gravity of the situation. The European Banking Authority (EBA) reported a staggering 129% increase in non-performing commercial real estate loans in Germany, reaching €14.2 billion by Q1 2024. The total volume of NPLs in Germany surged by 25% to €39.8 billion within the same period. Platt predicts this figure could escalate to €60 billion by the end of the year, driven by the refinancing challenges of loans maturing between 2024 and 2026. “This would represent an increase of more than 50 percent compared to the end of the first quarter. And even this figure could rise even further. This is because a large number of existing loans from the boom phase are due to mature in the next two years”, said Platt.
This could represent some good opportunities for investors, he said. For example, the growing volume of NPLs will lead to more sales of these non-performing loans. A lot is currently still taking place below the magic threshold of €100 million, above which it is attractive for Anglo-Saxon private equity and hedge funds to get involved. These investors, including many single and multi-family offices, have tended to act in the past much more quickly than their German institutional investor peers, who have traditionally been more reticent to enter the market until often well after the most favourable entry points.
Many German banks have also lost much of their relevant know-how and qualified staff in the lull since the last big NPL waves in 2003 and after the financial crisis. While banks may have stronger balance sheets now, they don’t necessarily have enough people on the underwriting side, said Platt.
Central Banks' warning: A crisis on the horizon
The supervisory authorities are also intensifying their scrutiny. The ECB’s targeted reviews and on-site inspections, coupled with BaFin's special audits, are compelling banks to reassess their loan portfolios. This increased oversight, particularly on so-called MaRisk requirements, is forcing banks to account for lower real estate market values, pushing them towards stringent action.
The Bank for International Settlements (BIS) echoes these concerns, forecasting a rise in loan defaults as a delayed consequence of previous high-interest rates. The BIS annual report warns that German banks are particularly vulnerable, with the proportion of bad loans for commercial properties rising sharply. The insolvency of the Trianon high-rise in Frankfurt, once a prestigious office location, exemplifies the sector's struggles, exacerbated by higher financing costs and declining valuations.
According to the Association of German Pfandbrief Banks (VdP), German office property values fell by 10.8% in 2023, a steeper decline than during the 2008 financial crisis. Retail property values are also plummeting, with VdP head Jens Tolckmitt predicting further declines. BIS Chief Economist Claudio Borio highlighted the risks, noting that commercial real estate has historically triggered significant stress in the banking sector. “Credit losses are still ahead of us”, he warned. Commercial real estate was "a much more typical source of stress in the banking sector in the past than residential real estate," he cautioned. Even small institutions could "trigger systemic problems on a broad scale" in the event of a crisis.
Germany’s financial watchdog BaFin is urging banks to increase their risk provisions to brace for economic uncertainties. In a recent article, Adam Ketessidis, President of BaFin's Risk Analysis, System Supervision, and Crisis Management Department, emphasised the need for preparedness. Despite a rise in corporate insolvencies, risk provisioning at significant banks remains insufficient. Ketessidis points out that current provisions, though increased, still fall short of what's necessary. He stresses that banks must prepare for potential downturns, considering the broader political and economic risks.
Insights from the DD Talks NPL Conference
At the recent DD Talks NPL conference in Barcelona, industry experts painted a grim picture of the commercial real estate loan market. Josh Silver, Director at APartners Capital, noted significant stress in the office market, especially for secondary offices suffering from low occupancy and high-interest rates. Banks face uncertainty regarding these loans, anticipating a substantial influx of distressed assets. "The office market specifically is where we see a lot of stress coming," said Silver.
Francesco Zanella, Managing Director of Acquisitions at Starwood Capital, emphasised that even prime properties are under pressure due to the sharp rise in interest rates. Initial property pricing, reflective of lower risk premiums, has dramatically shifted, complicating the situation for investors. Nikolay Golubev, Partner at Bain Capital, identified Germany, Austria, and the Nordics as regions with significant NPL opportunities due to their initially low interest rates and subsequent valuation drops. "There are potentially more opportunities to buy non-performing property loans in these markets because banks offered borrowers very low interest rates, meaning valuations were high, and any change in interest rates brought much bigger valuation drops than in southern Europe," Golubev said.
Handling the growing volume of NPLs requires specialised expertise, which many banks currently lack. Josh Silver highlighted the manpower shortage on the underwriting side, despite banks having the balance sheet capacity, validating Oliver Platt’s opinion (above). Francesco Zanella warned that the market's trajectory heavily depends on how banks manage repossessed properties. Forced sales could rapidly deteriorate market conditions, emphasising the need for skilled professionals to navigate these challenges. "The end of this cycle will depend a lot on how banks react to it," Zanella said. "If a lot of commercial property gets repossessed where people are forced to sell then we'll see a very damaged and distressed market pretty fast."
