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Covered Bonds Could Ease The Pain In European Commercial Real Estate


Table Of Contents: S&P Global Ratings Credit Rating Models


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Covered Bonds Could Ease The Pain In European Commercial Real Estate

Inflation and rising interest rates are taking a toll on European commercial real estate (CRE). CRE companies and commercial mortgage-backed securities (CMBS) continue to struggle with refinancing debt maturities, with CRE transactions happening at a slow pace and a smaller size. Even so, European banks' CRE exposure increased by 2.3% between the fourth quarter of 2022 and 2021 and contributed to an almost 1% rise in their loans to non-financial corporates in the same period.

Despite falling prices, CRE credit performance generally has remained relatively stable, but the number of nonperforming loans (NPLs) is rising in some markets. Multifamily housing assets, which are considered as residential in most countries and have largely been spared from pandemic-related disruptions, may also feel the strain as rental incomes are slow to adjust. While we believe that CRE asset performance may deteriorate, we do not anticipate it to significantly impair the credit quality of the covered bonds we rate. This is due to the availability of credit enhancement to absorb losses and the limited exposure to sectors that we consider to be more at risk.

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While we generally observe manageable CRE exposure in our rated cover pools due to high levels of unused overcollateralization (OC), we believe the repricing of CRE assets and requirements to frequently update valuations may lead issuers to change composition and, hence, some cover pools' risk profiles. However, in our view, covered bond issuers maintain the potential to help refinance CRE assets with longer term funding.


CRE Patchwork Across Europe

The changing operating environment has increased the focus on CRE assets that secure covered bonds. Compared to residential real estate, CRE faces stricter limitations, including lower maximum loan-to-value (LTV) ratios, and loans have shorter maturities and higher prepayment levels. Due to these characteristics, not all jurisdictions use the EU covered bond harmonization directive, which allows CRE exposure in cover pools. However, CRE assets continue to offer attractive margins for lenders, which may be one of the reasons why CRE cover pool exposures in Germany, Denmark, and Austria have increased year-on-year. We acknowledge that the appetite for CRE assets remain dependent on individual issuers and their business models.


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In our view, current price pressure on CRE could affect the volume and type of eligible CRE collateral and, therefore, the composition of cover pools. As prices decrease, a lower part of the loan may be eligible for the cover pool, which, in turn, could require cover pool management to replace or add further collateral.

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Covered Bonds Can Provide Stable Funding For CRE

Due to portfolio risk diversification, relatively low LTV ratios, excess OC, and most covered bond issuers' unused notches of collateral uplift for covered bond programs, covered bonds in Europe remain well positioned to withstand a correction in CRE prices.

In our opinion, covered bond issuers in Spain, where available OC remains comparably high, are particularly well positioned to increase CRE exposures. As a result of the updated covered bond law, most Spanish issuers lowered their current exposure and, in most cases, decreased the weighted average loan-to-value ratio (WALTV) of the included collateral.

By law, CRE exposure, excluding multifamily housing and tenant owner right associations, cannot exceed 10% of total assets in Sweden. But just like Spanish issuers, Swedish issuers benefit from comparably high levels of available OC, which could support covered bond issuance backed by multifamily or tenant owner right associations. Conversely, the recent CRE-driven growth in cover pools in Austria, Denmark, and Germany, combined with relatively higher WALTVs and lower OC levels, may lower the potential for further CRE funding in these countries.

Table 1

Current characteristics of CRE exposure in cover pools
WALTV* Average available OC* Average current % CRE*
Spain 38.4% 71.0% 11.7%
Austria 55.5% 51.0% 33.6%
Germany 49.1% 22.0% 70.6%
Denmark 42.7% 5.0% 28.7%
Sweden N/A 100.0% 15.5%
N/A--Not applicable. OC--Overcollateralization. WALTV--Weighted average loan-to-value ratio. *Based on issuers' harmonized transparency templates. N/A--Not applicable.

The dual-recourse feature of covered bonds allows issuers to deal with CRE's cyclicality. If market trends change, for example, issuing banks can take a longer view on credit performance and actively engage with borrowers to find solutions. Actively managed cover pools, low LTV ratios, and stable relationships mean banks and borrowers have more time to reach the best solution for troubled assets. On the downside, banks' support could stop underperforming assets from defaulting and increase the risk of non-performing assets in the cover pools.

CRE Increases Credit Risks In Covered Bonds

Our CRE criteria apply to diversified EU covered bond asset pools that consist partly or wholly of CRE mortgage loans. Due to potentially higher market value declines in the event of a default, we consider CRE assets to have a higher default probability and higher losses in the case 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. Accordingly, our base-case assumptions for expected defaults and market value declines in CRE are markedly higher than our residential mortgages assumptions. As these assumptions account for valuation volatility, we do not further adjust valuations.

The main factors that do affect our assessment of potential CRE asset performance are LTV ratio, property type, industry, location, and concentration risk. Generally, we expect losses to be higher as CRE levels in cover pools increase. Based on our sample of Austrian and German issuers, we observed that the perceived higher risk of CRE does not necessarily result in higher levels of available OC in programs with higher CRE levels.

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Due to lower LTV ratios or a focus on lower-risk residential housing associations, however, some issuers have large CRE exposures without an increase in S&P Global Ratings' expected losses. However, we consider the risks associated with multifamily properties as comparable to other CRE investments due to their reliance on rental incomes. This view also informs our credit analysis.

Country Snapshots

Following the European harmonization of covered bonds, covered bond laws are all based on Article 129 of the CRR. The regulation sets limits for CRE exposures and curbs potential credit risks.


Several German issuers' business models are mainly based on CRE financed by covered bond issuance. From a regulatory perspective, multifamily housing does not fall under CRE. German issuers are still required to use the so-called "Beleihungswert"--or mortgage lending value for loan origination. The "Beleihungswert" is generally well below market values. Issuers in Germany have taken advantage of available, longer-maturity funding options to lower refinancing risks. We believe covered bonds' longer funding profile may prove attractive to refinance CRE. The top three commercial exposures include office, multifamily, and retail.

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Only a few issuers in Denmark 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). The proportion of CRE in the cover pool reported is relatively small because Danish regulators treat the property type as "private rental," while we would normally consider it as "commercial" since it relies on rental income. Some Danish issuers include CRE loans from Germany and Sweden in their cover pools. We believe banks' relatively long and stable relationships with customers, support the generally low observed NPLs. The top four commercial exposures include private rentals, office, agriculture, and retail.

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The EU covered bond harmonization directive changed the cover pool definition and aligned the Spanish system with other European jurisdictions. Spanish issuers have used the opportunity to reconsider the role of CRE in cover pools. So far, they have lowered total CRE exposures and reduced WALTV ratios. Property developers now make up a comparably smaller part of cover pools. The top commercial exposures are retail and industry, while tourism is a further notable property type.

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Sweden, Austria, Finland, and Norway

Apart from Austria, these countries make less frequent use of CRE assets as security for covered bonds. CRE exposures in Sweden, Norway, and Finland are largely domestic, while Austrian banks have exposures to German and some Eastern European CRE. Norway requires commercial and residential properties to be kept in separate cover pools, Sweden and Finland limit CRE exposure to 10% of total assets, and in Austria, not all issuers include CRE in their cover pools.

While Austria's cover pools vary significantly in the use of CRE as a security, CRE generally plays a significant role in the collateral for covered bond issuance. The main commercial exposures include retail and office, while tourism is a further notable property type.

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Despite the generally limited CRE exposure, CRE assets could still affect smaller covered bond programs in Norway, Sweden, and Finland. The main exposure is multifamily housing and housing associations. Unlike CRE, there are no percentage limits for multifamily housing, which, on average, makes up only 2.5% in Norwegian cover pools. Multifamily housing and tenant owner associations represent the main asset type in Swedish cover pools.

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Related Criteria And Research

This report does not constitute a rating action.

Primary Credit Analyst:Casper R Andersen, Frankfurt + 49 69 33 999 208;

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