European business actual property: the cracks are beginning to present


From Canary Wharf in London to La Défense in Paris and Frankfurt’s Bankenviertel, the logos of major banks adorn Europe’s grandest office buildings. But there is early evidence that these buildings could become liabilities for banks and investors as they are buffeted by rising costs and post-Covid workplace changes.

Offices are the largest component of a commercial property market which lenders and investors have backed with €1.5tn of debt in Europe alone. About €310bn of new or replacement borrowing is issued to keep the market moving in a typical year, according to Bayes Business School at City, University of London.

Developers and landlords were already having to adjust to life since the pandemic began. This has involved an increase in hybrid working among their professional services tenants such as banks, law firms and consultancies, some of whom are reducing their office space. Now, in a key difference from the last downturn, property owners are having to contend with a rapid increase in borrowing costs as central banks ratchet up interest rates to contain a sharp rise in inflation.

Leverage has always been a central feature of commercial real estate but recent bank failures in the US and the state-brokered rescue of Credit Suisse by its rival UBS have added to fears that credit will become less available and more expensive. Property prices have already fallen sharply in recent months while older buildings in peripheral locations are becoming much harder to sell.

Analysts at Citi warned clients late last month that European real estate values had still not fully factored in rising interest rates and could fall by up to 40 per cent by the end of 2024.

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“You can definitely see the cracks starting to happen,” says Mark Bladon, head of real estate at Investec. In Frankfurt, the Korean owners of the 45-storey Trianon tower have hired advisers to begin restructuring the €375mn of debt secured against the building. Cheung Kei, a China-based investor, has put two buildings in London’s Canary Wharf business district up for sale to reduce its debt load, according to Bloomberg.

Blackstone, the world’s largest commercial real estate investor, defaulted on a loan secured against a Finnish office and retail portfolio last month, while loans against German apartment buildings backed by Brookfield were downgraded by the rating agency Moody’s in March.

The question worrying investors is whether what are fairly isolated cases of stressed assets will accelerate into a sector-wide crisis like that seen in 2008-2009, and inflict serious damage on Europe’s banks.

The European Central Bank has warned of “growing vulnerabilities” in property markets. “The commercial real estate sector is considered vulnerable to the impact of the pandemic, while medium-term risks of price corrections continue to grow in the residential real estate sector,” the central bank said in a supervisory report in February.

Most analysts think a rerun of the financial crisis, where souring loans against commercial property undermined banks’ capital, sometimes fatally, is unlikely. They predict a long period of painful adjustment rather than a short, sharp shock.

Office workers in La Defense financial district of Paris
Paris’s La Défense financial district. Citi analysts have warned that real estate values in Europe had not fully factored in rising interest rates and could fall by more than a third by the end of next year © Nathan Laine/Bloomberg

“This time around I am much more confident than I was in the global financial crisis, when I knew that something was going to go horribly wrong,” says Nicole Lux, senior research fellow at Bayes Business School. She does not expect problems in commercial real estate to infect the banking system, as they did in the global financial crisis.

But some investors worry it will be the other way around: the shock to commercial real estate may spare the banks but will be harder on asset owners. “I see losses hitting on the equity side and some distressed debt. The question is how long is it going to take?” says Raimondo Amabile, chief investment officer at PGIM real estate.

A different market

As anxiety hangs over European lenders after Credit Suisse’s travails, real estate executives have been quick to point out that commercial property borrowing has undergone a big shift since 2009.

“The danger with real estate is that people look at what happened in the [global financial crisis],” says Dan Riches, co-head of real estate finance at asset manager M&G. The market today has “more lenders, more equity, lower leverage in the system”, reducing the chance of large-scale stress.

Bar chart of Maximum loan-to-value for commerical property by country (%) showing German lenders allow the most leverage in Europe

In the run-up to 2008, lenders routinely offered loans of 80 or even 100 per cent of a building’s value, sometimes basing their lending on optimistic forecasts about rental income or capital values. Bayes’ research found that European lenders would now rarely go beyond 60 per cent of a property’s value, making it less likely that the outstanding debt would end up exceeding the value of the property.

German lenders are more liberal, the research found, with maximum LTVs of 80 per cent for good-quality assets. In the UK, the consultancy Capital Economics said that four-fifths of loans were below a 60 per cent loan-to-value ratio — and that overall UK bank exposure to commercial real estate was half what it was in the run-up to the financial crisis.

But another vital difference between then and now is the trajectory of borrowing costs. As the world’s financial system threatened to seize up in 2008, central banks slashed interest rates and then flooded money markets with emergency cash. That made it relatively easy for even heavily indebted landlords to wait for the crisis to pass. Banks, keen to avoid crystallising losses that would further erode their own capital, were often happy to extend borrowing facilities.

Offices in Frankfurt, Germany’s financial centre
Offices in Frankfurt, Germany’s financial centre. UBS forecasts that major German landlords’ average loan-to-value ratio will rise to nearly 50 per cent this year, up from 44 per cent in 2021 © Michael Probst/AP

This time, stubbornly high inflation has meant central banks have continued to push debt costs higher — despite the cracks in the banking sector and strains on commercial real estate. Bayes research suggests the cost of borrowing against prime real estate in Europe has doubled year on year. Some industry experts predict that, faced with steep increases in their own funding costs, banks will be less inclined to show forbearance towards struggling borrowers.

“You could describe a better story going into the global financial crisis than you could today,” says one senior executive at a large property investor. “There is no way out that will be fixed by the market.”

The first domino

First in line to take losses will be the owners of lower-grade office buildings. Amabile, of PGIM, says they face a “perfect storm” of weaker underlying demand for space, higher construction and maintenance costs, fewer potential buyers or lenders, and higher interest charges.

“We are really talking about stranded assets I think. We haven’t really seen that emerge since the retail [property] crash in 2018 and 2019,” says Zac Gauge, a real estate strategist at UBS. “I can’t see anything changing on the upside that is going to create tons of demand for secondary offices.” 

In the US, a slower return to in-person work has left even some prime offices facing financial difficulty. The vacancy rate there at the end of 2022 was 19 per cent, according to the real estate adviser JLL. But while the headline European vacancy rate is half that, the market is split between robust appetite for attractive buildings that meet the latest environmental standards and little demand for other space.

One US investor in European real estate says that occupiers there “are taking smaller footprints and moving into better buildings”. Prices for less desirable offices could fall by more than 50 per cent, some investors predict, as developers will have to totally repurpose the buildings. Both the EU and the UK are phasing in new energy efficiency standards that will require heavy investment from the owners of old buildings.

“Your bigger problem is the guy who has to refinance in the next few years for five [years] and thinks the building is a security, [then] realises he has a $10mn bill to bring it up to [environmental standards],” says Andrew Coombs, chief executive of Sirius Real Estate.

A line chart showing office vacancy rates in the US, Asia-Pacific and Europe. showing that vacancy rates are rising everywhere, but remain lower in Europe

All the headwinds and uncertainty are making it harder to find investors with the confidence to buy offices or lend to their owners. “The big question everyone is asking is: what is the value of an office?” says Isabelle Scemama, global head of alternatives at French insurance group AXA.

It is a question that will take some time to answer because the European market typically reflects pricing changes more slowly than the UK or the US. “Generally speaking, valuers in Europe look at comparative transactions. If you have periods of lower transaction volumes with less evidence, valuers take a bit longer,” says Oliver Moldenhauer, analyst at Moody’s. That slow pace of deals can become a vicious cycle, where fewer transactions result in fewer yardsticks for the true value of buildings and more difficulties pricing sales.

Who takes the hit?

When values do start to fall in earnest, borrowers will be pushed closer to lender-imposed conditions about loan-to-value ratio and interest cover. That could lead to painful conversations with creditors, especially as old loans near expiry and need to be refinanced with much more expensive borrowings.

“You have some companies that have not been savvy enough to fix their debt or refinance early,” says Colm Lauder, analyst at the brokerage Goodbody. Germany’s listed landlords have among the highest debt levels; UBS forecasts that major German landlords’ average loan-to-value ratio will rise to nearly 50 per cent this year, up from 44 per cent in 2021.

Some assets, and likely some companies, will need a fresh injection of equity to reduce the leverage in their capital structures. In more extreme scenarios, they may have to sell assets to pay down debt. Real estate executives will find themselves heading into these high-stakes talks just as banks have less room to be lenient because turmoil in the financial sector has damped their tolerance for risk.

“There were a lot of borrowers who were on borrowed time,” says Gauge. “That may accelerate, and they may find that they have even fewer options to refinance when the time comes, if any.”

Euan Gatfield, an analyst at rating agency Fitch, says it is “fair to say that commercial real estate is among the weaker of the range of assets that banks have exposure to”.

“In the very short term we may see banks navel gaze a bit and make sure that they go over what they have got on their balance sheet, at the expense of new origination.” 

Net lending to commercial property in the UK turned negative to the tune of £288mn in February, for the first time since August. Capital Economics analysts expect that pull back will accelerate given the banking turmoil, “which will constrain the eventual recovery in investment and construction”.

The chief concern is a wave of forced selling from over-extended asset owners or debt funds, which would further depress the value of assets and create a downward spiral.

A view of the London skyline from Greenwich in the city’s south-east
A view of the London skyline from Greenwich in the city’s south-east. Net lending to commercial property in the UK turned negative in February, for the first time since last summer © John Keeble/Getty Images

The ECB this month urged regulators to develop policies that prevent liquidity mismatches in open-ended property funds, which own assets that take a long time to sell but promise to repay investors on demand. It fears that fire sales of assets to meet redemptions could amplify existing stresses.

Commercial real estate makes up 9 per cent of European banks’ loan book, on average, according to Goldman Sachs, and 15 per cent of non-performing loans. That is notably less than US banks, which have 25 per cent of their loan books in the sector, rising to 65 per cent for the smaller US lenders that have been the focus of recent stress.

But the European average hides a wide range. Nordic banks had the largest commercial property exposure, according to an S&P Global Market Intelligence report late last year, such as Sweden’s Svenska Handelsbanken, which had 40 per cent of its retail and corporate loans out to commercial property. HSBC, whose real estate lending has grown in recent years, still had only 11 per cent exposure, S&P said.

Banks are not the only lenders, however. “What concerns me is outside the banking sector, what is called ‘shadow banking’,” says Lux, of Bayes Business School. “Private debt funds are unregulated at this point.” 

Bladon, of Investec, says that alternative lenders now occupy the terrain that banks held during the financial crisis. “The debt funds that have stepped into that highly leveraged space have got to be in a worse position [than banks].”

But the growth of alternative sources of lending such as asset managers, sovereign wealth funds and private equity firms could also provide a key source of financing for the industry as banks draw in their horns, according to Ron Dickerman, president of investment group Madison International Realty.

Some of the demand for loans and fresh investment could be met by funds that raised large amounts of cash in recent years and have yet to deploy it, as well as overseas investors. But they may also choose to invest those funds outside the challenged office and retail markets. Citi analysts say that logistics, self-storage and some residential assets should fare better than traditional office space.

“A lot of funds and investors are very hungry for deals . . . The fundamentals are still strong and there are opportunities in certain key market sectors, unlike the past,” said Anthony Mongone, real estate partner at the law firm Ropes & Gray. “I think it may not be a total gloom and doom story. It may be more of an isolated doom and gloom story.”


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