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Commercial Real Estate In Covered Bonds: Is It Worth The Risk?


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Commercial Real Estate In Covered Bonds: Is It Worth The Risk?

The negative effects of the COVID-19 pandemic are beginning to subside, and the focus is moving toward recovery. During the COVID-19 crisis, covered bonds benefited from better-than-expected property markets performance. But despite this relatively strong asset performance, recovery has not been equal across commercial real estate (CRE) assets. Sectors such as retail, hotels, and even offices continue to be affected by the changes in customer behavior brought on by the crisis.

The divergence of asset performance has created increased investor interest in the characteristics of CRE assets securing covered bonds. Further, the increased investor focus on environmental, social, and governance (ESG) factors as part of their investment decision has put a spotlight on CRE's ESG characteristics. This is demonstrated by the high number of green covered bonds issuances partly backed by CRE assets.

Although CRE is allowed in most covered bond jurisdictions, the limitations on the assets--such as the maximum LTV--are normally stricter than those for residential real estate. And because commercial assets tend to have shorter maturities and higher prepayments, they are not as commonly used as cover pool security in many jurisdictions.

Chart 1


Covered Bonds Support Commercial Real Estate Despite COVID-19-Related Pressures

In our view, the dual-recourse feature of covered bonds allows issuers to deal with CRE's cyclicality. The issuing bank can take a longer view on credit performance and actively engage with borrowers to find solutions if market trends change. The active management of the cover pool, low LTVs, and continued relationships with borrowers help ensure that the bank and the borrowers have more time to reach the best solution for troubled assets. On the downside, the support of the bank could keep underperforming assets from defaulting and risk restructuring being at the cost of the cover pool.

Regardless, CRE continues to offer issuers attractive margins, while the asset barely affects the cost of funding for the issued covered bonds. The perceived higher credit risk of CRE compared to residential real estate currently does not affect covered bond pricing. Some of this is due to the dual-recourse to the issuer, but the ECB's CB purchase program does not differentiate demand based on collateral, which means less price difference, and so investors are not likely to be compensated for the higher perceived credit risk.

Commercial Real Estate Increases Credit Risk In Covered Bonds

Our CRE criteria apply to the analysis of diversified European covered bond asset pools that consist partly or wholly of CRE mortgage loans. The criteria consider CRE assets to have a higher potential probability of default (base default frequency; BDF) and higher losses (weighted-average loss severity; WALS) due to higher market value decline (MVD) assumptions in the event of a default. We also consider the servicing of such assets to be more expensive and the haircut to liquidize such assets to be higher than for residential real estate.

These factors affect the level of overcollateralization necessary for the ratings. Base assumptions for expected default and MVDs are markedly higher than the assumptions for residential mortgages. Given our criteria's markedly higher levels of MVD assumptions, we do not further adjust valuations, as we believe these assumptions account for valuation volatility.

The main factors affecting our assessment of potential asset performance are LTV, property type, industry, location, and concentration risk. Chart 2 displays the increased expected loss depending on level of real estate exposure in covered bond programs rated by S&P Global Ratings. Some issuers have larger CRE exposures without an increase in expected losses due to lower LTVs or a focus on lower risk housing associations.

Chart 2


Covered Bonds With The Largest Commercial Real Estate Exposure

The total volume of CRE assets does not necessarily speak to the overall credit risk of a covered bond program. Often the main asset type securing covered bonds remain single family housing, apartments, or holiday homes. The percentage of CRE assets differs significantly from program to program but also between jurisdictions (see chart 3). Given the higher cyclicality of CRE, even lower levels of CRE exposure have the potential to affect overall credit performance.

Chart 3


Characteristics Of The Main Covered Bond Jurisdictions With Commercial Real Estate

Generally, covered bond laws are modeled on Article 129 of the capital requirement regulation (CRR), with sets limits for CRE exposures, to allow their preferential capital treatment. In our view, the main strengths of the covered bonds remain the legal frameworks, which limit CRE's potential credit risks.

Chart 4


Significant CRE exposure is mainly a feature in long-established covered bond jurisdictions. Coincidentally, these markets--Denmark, Germany, and Spain--are also among the biggest issuers of covered bonds in Europe. Table 1 summarizes the main characteristics of these markets.

Table 1


Commercial Real Estate Sector Outlooks

As mass vaccinations are becoming more widespread, the recovery might be faster than expected, while uncertainty remains for hotels due to travel restrictions, and offices due to subdued demand in most European markets. Please find all relevant research in the Related Research section.

Table 2


Germany--CRE Is The Name Of The Game

The business model of several German issuers is mainly based on CRE financed by the issuance of covered bonds. A significant number of issuers have diversified geographically outside Germany. Issuers remove nonperforming loans (NPLs) from the cover pool, which ensures relatively low NPL levels as long as the issuer can support the cover pool.

Top three German covered bond issuers with CRE exposure

Chart 5A


Chart 5B


Chart 5C


Denmark--Mortgages Matching The Covered Bond

A few issuers focus exclusively on specialized lending to certain commercial segments. These include DLR Kredit (agriculture), Danish Ship finance (ships), and Danske Bank's cover pool C (CRE in Norway). NPLs remain in the cover pool, but levels stayed low though the COVID-19 crisis. This might be due to the relatively long relationships with customers (seasoning), which may have helped ensure forthcoming support to the borrowers.

Top three Danish covered bond issuers with CRE exposure

Chart 6A


Chart 6B


Chart 6C


Spain--The Whole Mortgage Balance Sheet

As the whole un-securitized mortgage book serves as collateral, the exposure reflects the total mortgage balance sheet of the individual issuer instead of that of a designated cover pool. EU harmonization will likely change this and align the Spanish system with those of other European jurisdictions. Spain was particularly hard hit by the Great Financial Crisis, and some issuers continue to report comparably high levels of NPLs within in their CRE portfolios.

Top three Spanish covered bond issuers with CRE exposure

Chart 7A


Chart 7B


Chart 7C


Sweden, Austria, Finland, And Norway--The Best Of The Rest

While the focus is largely on the countries with the most CRE exposure, other jurisdictions frequently make use of these assets as security for covered bonds. For these countries, exposures are largely domestic. While kept in separate cover pools in Norway, limited to 10% of total assets in Sweden and Finland, and not present in every Austrian cover pool, the assets affect our view of credit risk. Despite the generally limited exposure, such assets could affect smaller programs.

Although Finland, Sweden, and Norway limit commercial exposure in cover pools, the limits do not affect multi-family housing, which makes up a noteworthy part of security in a number of cover pools in those jurisdictions. The Austrian framework mirrors the German framework described above, while Austria's cover pools vary significantly in the use of CRE as security: between 0% to more than 40% of the total pool balance.

Other European jurisdictions: top three covered bond issuers with CRE exposure

Chart 8A


Chart 8B


Chart 8C


Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Casper R Andersen, Frankfurt + 49 69 33 999 208;
Secondary Contact:Barbara Florian, Milan + 390272111265;

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