Souring US commercial real estate loans hit German banks' asset quality in Q2

US commercial property remains a drag on the asset quality of exposed German lenders, which flagged more problem loans related to the sector over the second quarter of 2024.

Specialist commercial real estate (CRE) lenders Aareal Bank AG and Deutsche Pfandbriefbank AG (PBB) as well as Germany's largest lender, Deutsche Bank AG, said their exposure to US office properties in particular is an ongoing concern amid high vacancy rates and declining valuations. In the second quarter, all three banks saw problem loans as a share of gross loans increase from the previous three months as well as from a year ago, according to S&P Global Market Intelligence data.

US CRE takes up the largest share of property nonperforming loans (NPLs) at Aareal Bank and PBB and has accounted for over a quarter of Deutsche Bank's credit loss provisions since late 2023, company filings show. All three banks are focused on restructuring problem loans in their US CRE books as well as reducing their overall exposure via NPL and performing loan sales.

While Deutsche Bank has flagged a larger absolute amount of high-risk loans in its US CRE portfolio compared to the sector NPLs booked by Aareal Bank and PBB, these loans account for a far smaller share of the group's much larger and more diversified loan book.

Short sellers target PBB

PBB in particular has been in the crosshairs of short sellers since the beginning of 2024 when it emerged as the most-shorted stock among European banks, which was still the case in the middle of August this year, according to Market Intelligence data.

Short sellers make money by borrowing stocks they expect to lose value, selling them on the open market, then buying them back later at a lower price before returning them to the original owner.

European banks with high CRE exposure have been among the most-shorted stocks so far in 2024 as commercial property valuations across big markets, such as the US and Germany, have plummeted amid rising interest rates.

While PBB has managed to ease some of the pressure on its CRE book by restructuring NPLs linked to US office properties, analysts project elevated asset quality risks linked to that segment for the whole of 2024.

"The US loan portfolio, which is entirely office related, remains a weak spot and the inflows in total PBB [NPLs] came entirely from this region," ABN Amro Head of Credit Strategy Shanawaz Bhimji said in an Aug. 14 research note.

PBB hiked its loan loss provisions to €63 million in the second quarter from €37 million in the first quarter due to higher NPLs, mostly driven by US office loans.

PBB did not respond to a request for comment.

Asset quality risks

The outlook for US office attendance is still mixed and "it is too early to call for a turning point in NPL or provisioning development," Bhimji said.

US loans accounted for 48% of PBB's total NPLs and office loans accounted for 61% of total NPLs as of June 30, higher proportions than the ones booked three months ago when US NPLs were 41% and office NPLs were 53% of total NPLs, bank filings show.

Expected rate cuts in the second half of 2024 would support a gradual recovery in the US CRE market and PBB's credit losses would start to tick down compared to the first half of this year, according to an Aug. 14 report by S&P Global Ratings. Yet if rates stay higher for longer, the bank could face further asset quality problems. PBB's credit losses for full year 2024 are expected to reach as high as 45 basis points, according to the report.

US office loans are also deemed "the largest drag" on Aareal Bank's asset quality in 2024 despite a somewhat better outlook for the second half of the year, ABN Amro's Bhimji said in an Aug. 8 note. The share of US NPLs in Aareal Bank's total NPLs rose to 73% as of June 30, from 67% as of March 30, bank filings show. The share of office property NPLs edged down to 58% from 59% in the same period.

Aareal Bank has earmarked €300 million of property NPLs for resolution in the third quarter of 2024, yet it is too early to say whether there would be new NPL inflows in the coming months, Chief Market Officer Christof Winkelmann said during an Aug. 8 earnings call. Risks are concentrated in the US as the bank has not seen "a single NPL in the office segment in Europe since 2022," Winkelmann said.

The bank has not added new business in the US office portfolio in 2024 and continues to monitor that loan book closely, interacting "early and regularly" with borrowers, a spokesperson for the bank told Market Intelligence. The bank's overall asset quality has improved with loan-to-value "averaging an excellent 56%," remaining stable compared to the end of 2023, the spokesperson said.

Deutsche Bank's higher provisions

Deutsche Bank said the slow recovery in the US office market would likely lead to a higher-than-previously-expected cost of risk in 2024, changing its full-year guidance for the share of credit loss provisions in average loans to "slightly above 30 basis points" from the previous target range of 25 to 30 basis points.

The beginnings of a CRE market recovery the group had expected to see had not yet materialized, CFO James von Moltke said during a July 24 earnings call. Despite some stabilization expected for the broader US CRE sector in the second half of 2024, the US office CRE portfolio will continue to be impacted, affecting the provisions outlook, the CFO said.

US CRE-linked credit loss provisions have accounted for over 25% of group provisions since the last quarter of 2023, company filings show.

Commenting on provisioning outlook for 2024, a spokesperson for Deutsche Bank told Market Intelligence that the new guidance reflects "moderately lower commercial real estate provisions, although the improvement in this area is moving at a slower-than-expected pace."

The US accounts for over half of total high-risk loans in Deutsche Bank's nonrecourse CRE book, company filings show. Nonrecourse debt prevents the lender from seeking further financial compensation or other assets than the collateral in case of a borrower default.

Deutsche Bank is looking to offload $1 billion in US CRE loans in order to free up capital, Bloomberg reported Aug. 1, citing people familiar with the matter.