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Credit FAQ: Spotlight On Refinancing Risks In European Commercial Real Estate

The three weeks after March 10, 2023, saw significant volatility in the U.S. and European banking sectors. Two U.S. regional banks failed (Silicon Valley Bank and Signature Bank), one of the 30 global systemically important banks, Credit Suisse, lost its independence after a government-facilitated takeover by UBS, and market and depositor confidence in parts of the sector evaporated. Following the strong policy response and a letup in the jittery market sentiment, volatility has since eased moderately.

Yet, confidence in the banking system remains fragile. This puts more strain on European commercial real estate (CRE) holding companies who rely heavily on bank funding to refinance debt maturities and are already struggling with rising interest rate-induced devaluation pressures and structural changes in the office property segment. We take a look at some of investors' most pressing questions on CRE refinancing risks, both from a bank and a real estate investment trust (REIT)/real estate operating company (REOC) perspective.

Frequently Asked Questions

Have you noticed an uptick in refinancing risks in the European real estate sector?

We have already seen an increase in refinancing risks in 2022 since most real estate corporates could not access capital markets and bank lending became more expensive than before because of rising interest rates (see "When Rates Rise: European REITs' Funding Costs And Cap Rates Climb, So Does Revenue," published June 16, 2022). With their large investments and property-heavy balance sheets, real estate companies are capital-intensive and need regular capital access to refinance their ongoing debt maturities. Refinancing risks are higher for Nordic and hybrid capital-intensive REITs/REOCs. That is due to shorter debt tenure and the potential replacement of instruments after the first optional call dates.

How have you reflected these risks in your rating actions so far?

Of the 68 REITs/REOCs we rate, we have downgraded 10 (through 16 rating changes) and revised the outlook for 11 to negative over the last 12 months. Refinancing pressure and high leverage metrics underpinned most of these rating actions, particularly for REITs that had been active in debt-funded mergers and acquisitions in the preceding years and had more material refinancing and deleveraging needs within a short-term horizon. Of our rated real estate companies, 19% still have a negative outlook, which highlights the risk of further downgrades this year.

How have recent banking sector stresses in the U.S. and Europe affected European REIT/REOC's current refinancing plans?

For now, access to bank lending has not deteriorated and margins have only moderately increased. The majority of REITs we rate maintain solid relationships with their existing banks. Until recently, they were still able to raise bank loans at more attractive conditions than bonds, particularly in the mortgage lending segment. They also enjoy wide headroom under bank covenants, whose maximum LTV ratios are typically around 60% for a revolving credit facility and are based on more lenient ratio definitions than S&P Global Ratings-adjusted debt-to-debt and equity (D/D+E) ratios (see chart 1).

That said, we understand that banks are selective with new real estate clients or new transactions. They are attentive to valuations, as demonstrated by low loan-to-value (LTV) starting points on mortgage secured lending and could potentially raise margins further. Getting new funding could be more difficult for companies with limited bank relationships, tight covenant headroom, or limited unencumbered assets. Obtaining bank financing on new property developments, especially speculative ones that are not pre-let and riskier by nature, will likely become harder. In the medium run, we think lending conditions could tighten if and when operating indicators for real estate companies worsen. Any weakening in fundamentals, like occupancy ratio, negative reversion, or asset valuation, is likely to make it more challenging to obtain refinancing in a timely and competitive manner.

Chart 1


How material are CRE exposures for European banks, and what were recent trends?

Based on data from the European Banking Authority (EBA), CRE loans represent around 10% of large EU banks' total lending portfolios. German and Swedish banks stand out, with CRE loans making up 19% and 18% of customer loan portfolios. For these large EU banks, growth in CRE loans has been relatively limited in the past three years, with a compound annual growth rate (CAGR) of 3%. Notable exceptions are French and Belgian banks with double-digit CAGRs.

Since these numbers cover large EU banks at a consolidated level, they also include global CRE lending exposures. For example, parts of large German banks' CRE portfolios have an international exposure, primarily to the U.S. That said, CRE comprises a wide range of activities, including lending to housing associations, which, in some countries, is usually state-guaranteed with low default risk.

Chart 2


Are CRE exposures concentrated within smaller European banks?

We estimate that the EU's 33 largest banks, whose total assets exceed €200 billion, hold around 75% of CRE bank lending. 82 smaller banks, with assets of less than €200 billion, hold the remaining 25%. In other words, larger players dominate the CRE lending market.

That said, several banks have a very high CRE loan concentration (see table 1). As of June 2022, 49 large European banks had a CRE exposure on a par with or superior to common equity Tier 1 (CET1) capital. Based on the EBA classification, some of the top 20 banks' CRE portfolios have recently expanded rapidly. The EBA classification of CRE exposures is relatively broad and does not differentiate between the types and risk profiles of underlying CRE collateral, be it office, retail, or industrial properties. As such, we consider these findings as a starting point for our analysis of CRE-related risks for banks.

Table 1

Selected Rated European Banks With CRE Exposures In Excess Of CET 1 Capital
Bank CRE loans, June 2020 (mil. €) CRE loans, June 2022 (mil. €) Nominal growth in CRE loans, June 2020-2022 (%) Share of CRE loans (% of total customer loans), June 2020 Share of CRE loans (% of total customer loans), June 2022 Percentage point growth in CRE loans relative to customer loans CET 1 capital, June 2022 (mil. €) CRE loans relative to CET 1 capital, June 22 (x)
Aareal Bank AG* 21,857 27,294 25 90.1 91.9 1.8 2,579 10.6
Deutsche Pfandbriefbank AG 20,723 22,560 9 73.7 77.4 3.7 2,841 7.9
Erwerbsgesellschaft der S-Finanzgruppe mbH & Co. KG* 20,758 29,670 43 41 54.4 13.4 4,542 6.5
Jyske Bank A/S 1,817 23,406 1188 3.2 41.8 38.6 4,670 5
Svenska Handelsbanken AB 67,698 70,669 4 31.3 34 2.7 14,486 4.9
AS LHV Group* 694 1,181 70 39.8 43.2 3.3 333 3.5
Bayerische Landesbank* 46,129 30,401 -34 38.9 23.9 -15 10,506 2.9
Bank of Cyprus Holdings PLC 3,962 3,991 1 35.5 39.3 3.8 1,499 2.7
Volksbanken Verbund* 4,224 4,568 8 20.1 21.2 1.1 1,948 2.3
Akcine bendrove Šiauliu bankas* 729 878 20 42.5 38.1 -4.4 382 2.3
Coöperatieve Rabobank U.A. 84,772 83,435 -2 21 19.7 -1.3 37,861 2.2
Landesbank Hessen-Thüringen Girozentrale* 18,419 19,578 6 24.5 24.8 0.3 8,887 2.2
SpareBank 1 SR-Bank ASA* 3,965 4,809 21 18.9 19.6 0.7 2,239 2.1
Raiffeisenbankengruppe OÖ Verbund eGen* 7,043 8,417 19 30.8 33.3 2.5 4,225 2
SpareBank 1 SMN* 2,331 3,472 49 13.7 16.9 3.1 1,834 1.9
Akciju sabiedriba "Citadele banka"* 532 698 31 35.1 23.8 -11.3 378 1.8
Piraeus Financial Holdings S.A. 12,175 6,363 -48 26.3 21.8 -4.5 3,474 1.8
Norddeutsche Landesbank Girozentrale* 14,139 10,034 -29 25.1 20.1 -5 5,618 1.8
Hamburg Commercial Bank AG* 9,366 6,819 -27 39.1 41.1 2 3,897 1.7
Nordea Bank Abp 18,256 43,173 136 6.3 13.7 7.3 25,031 1.7
*Not rated. CET 1--Common equity tier 1. CRE--Commercial real estate. Source: European Banking Authority, S&P Global Ratings.
How do you assess the overall quality of European banks' CRE underwriting?

It is hard to gauge the quality of European banks' CRE underwriting, given the lack of standardized data on this topic. However, the average LTV ratio which seems to be relatively conservative, can help to shed some light on this. European Systemic Risk Board (ESRB) data indicate that most CRE loans have LTV ratios of 60% or less, but regional differences apply. More than half of CRE loans in Greece, for example, have LTVs above 80%. That is in stark contrast to France and Germany where the proportion of CRE loans with LTV ratios beyond 80% hovers around 20% and less. It is worth noting, however, that the ESRB itself recommends using LTV data with caution, owing to the quality of the data.

Do European banks have the capacity and willingness to lend to the CRE sector?

Due to healthy capital and liquidity metrics, European banks certainly have the capacity to lend to the economy in general and the CRE sector in particular. The recent market volatility does not fundamentally change our base case expectation that European banks will be resilient, albeit divergent, as the economic reset kicks in (See "European Banks Can Weather The Market Turmoil," March 21, 2023). Banks' willingness to lend, however, is a more nuanced story.

The latest ECB bank lending survey, conducted in the last quarter of 2022, indicated a further tightening of credit standards by banks. Banks' risk assessment of the overall economic outlook and their declining risk tolerance were the main factors behind the tightening, which was particularly pronounced in the CRE and construction sectors.

Due to the recent market turmoil and mounting anecdotal evidence of distress in certain parts of the CRE markets, we expect banks will maintain their cautious stance on the CRE sector and continue to have a very selective approach. While they will likely refinance customers with established relationships, banks will be reluctant to accept new clients and to grow their overall CRE book. Increasing scrutiny from investors and market participants is also weighing on banks' risk appetite for CRE lending, at least for the foreseeable future.

How would significantly declining valuations affect European banks' attitude toward CRE lending?

Banks' relatively sound origination practices, including their previously mentioned relatively low LTV ratios, would provide some protection against losses if valuations declined significantly. Falling collateral values, however, would trigger some risk limits or covenants, meaning banks would have to negotiate with borrowers to reduce leverage levels.

Under our base case scenario of a complicated but not dire economic environment and banks maintaining resilient balance sheets, we expect banks will have the means and incentives to support existing clients. They will not want to trigger a negative feedback loop, with fire sales hitting collateral valuations and ultimately increasing credit costs. A scenario like that might materialize if economic conditions worsen. In the case of a severe recession, for example, banks would likely take more defensive actions to protect their balance sheets.

On the other hand, gradually stabilizing interest rates and valuations could, over time, incentivize banks to take a more constructive approach to CRE lending. Amid rising interest rates, banks' loan repricing outpaces their rising funding costs, resulting in widening margins and further incentives to lend.

What if bank lending to European REITs/REOCs was to shrink?

It would put additional pressure on REIT/REOCs' refinancing plans. Without bonds, REIT/REOCs' reliance on bank lending, be it secured or unsecured, has increased. We expect them to increase the share of alternative sources of capital. So far, most companies have prioritized replacing bond maturities with proceeds from disposals and, sometimes, equity raises. That way, they can contain their exposure to mortgage debt and limit the impact of higher interest rates on their EBITDA-to-interest coverage ratio. Based on a combination of increasing revenues and a decrease in capex and dividends, we also expect REIT/REOCs to generate more positive discretionary cash flows between 2023 and 2025 than they did previously.

Are European REITs/REOCs able to dispose assets?

It remains difficult. Transactions are happening, but at a slow pace or smaller size. Transacted amounts are still subdued. They were low in 2022, down 12% according to a report from BNP Paribas Real Estate, particularly in the last quarter (down 55% versus the last quarter of 2021). The office segment was the most impacted (-20%), but also logistics (-19%) and hotels (-11%). Transaction volumes in the first quarter of 2023 remained weak, down 59% compared to the first quarter of 2022, according to a report from property agent Savills, and among the lowest Q1 transaction numbers since the global financial crisis. This is due to a continuous price mismatch between sellers and buyers, who are both on the sidelines. While no major distressed sales have happened yet, large transactions without a price discount are difficult to materialize in the current environment. We do not expect the investment market to revive fully before 2024. Investors will want to keep an eye on important catalysts like terminal rates stabilization, which we expect by the end of 2023, and the capacity to pass through high inflation into lease indexation this year. Clarity on both factors should help bridge the bid-ask gap. It is also worth noting that cross-border investment in European assets, for example from Asia, has recently increased, which could fuel investments for the remainder of the year.

Is there a risk that one of the European real estate companies you have rated as investment grade could default this year?

No, because liquidity needs for all investment-grade REITs are fully covered over the next 12 months and, in most cases, well beyond that. We expect companies to work on refinancing well ahead of debt maturities and/or back them with liquidity sources such as cash and cash equivalents, undrawn bank lines, proceeds from disposals, and funds from operations (FFO).

What could trigger rating downgrades?

A material deterioration of a company's liquidity cushion or difficulty to address 2024 debt maturities could prompt us to lower a rating. We also monitor average debt durations closely, as less than three years of remaining maturity or large portions of debt that require refinancing every year could expose companies to refinancing risks and, ultimately, the risk of downgrades.

Do you see challenges in the European office market?

Yes. The increase in working from home and sluggish economic growth could weaken tenant demand in Europe this year and lead to more vacancy and/or rent pressure, depending on local supply and demand. Combined with low yields, this could also result in further revaluation losses, which is something we consider in our rating assumptions.

We expect a widening gap between grade-A assets, located in central districts, and grade-B assets, located in peripheral locations. The former continue to benefit from strong tenant demand and see rising rents, decreasing rent incentives, and steadily low vacancies (2.3% in the Paris central business district, 3% in Cologne, 3.1% in Berlin, and 3.6% in Stockholm, according to a recent report from Savills). Grade-B and peripheral assets, on the other hand, already face pressures on occupancy, effective rents, and valuations.

Sustainability standards regulations are also likely to tighten in Europe, with the U.K. now requiring a minimum energy performance rating for commercial properties. We think this should add further pressure on grade-B assets' valuations in the next few years.

Tenants are also putting more emphasis on energy-efficient buildings and the quality of the surrounding environment, notably to attract talent. Amenities such as restaurants, stores, entertainment venues, and public transportation are certainly a plus.

Moreover, utilization rates across Europe show disparities, with the U.K., and London in particular, lagging behind countries like France, Spain, and Sweden. In general, European countries tend to have higher utilization and occupancy ratios than the U.S. According to recent data from real estate adviser Jones Lang LaSalle, average vacancy in the five largest office cities in the U.S. is 22.12% (ranging from 15.9% to 25.1%), compared to only 7.5% in Europe (4.4% to 11.3%).

Finally, tenant quality is important. A tenant mix comprising small and medium sized enterprises and concentrated industries represents a risk for landlords. Most investment-grade rated REITs in Europe are mainly exposed to creditworthy tenants, mainly large institutions in diversified sectors, which have the capacity to pay rents and can afford high indexation. We expect indexation to remain robust this year, which could mitigate a potential drop in occupancy and/or market rents. European leases are widely indexed to inflation and, generally, capture inflation with a six to 12 months' time lag.

Related Research

This report does not constitute a rating action.

Primary Credit Analysts:Franck Delage, Paris + 33 14 420 6778;
Nicolas Charnay, Frankfurt +49 69 3399 9218;
Secondary Contacts:Marie-Aude Vialle, Paris +33 6 15 66 90 56;
Nicole Reinhardt, Frankfurt + 49 693 399 9303;
Osman Sattar, FCA, London + 44 20 7176 7198;

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