Commercial Real Estate Down Payment Assistance – The commercial real estate market is under pressure in Europe and elsewhere as prices fall and activity comes to a standstill in many countries. The commercial real estate sector poses risks to euro area banks and financial stability. More than a decade ago, the European Stability Mechanism was called in to bail out countries trapped in sovereign banks caused by bursting asset bubbles. But today the risk seems less systemic than before and banks are better equipped to deal with stress. In this blog, we use our past crisis experiences to examine the current situation and explain why we are not facing the same problem.
Trouble in commercial real estate could threaten the financial stability of European banks in the current environment of high inflation and rapidly rising interest rates. Rising interest rates squeeze the profits of commercial real estate companies as they tend to rely on debt financing and the cost of servicing debts becomes burdensome. During the decade of low interest rates from 2012-2022, yield investors pushed up commercial real estate prices and compressed rental spending (see Figure 1). At the same time, commercial real estate companies in many countries have increased their leverage, meaning that a relatively small increase in debt service can turn profits into losses.
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Note: The cost of financing commercial real estate debt is estimated by adding an estimated spread of 200 basis points to the five-year government bond yield for the euro area.
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Heavy reliance on high-cost loan financing is reducing profits, driving down real estate prices and freezing markets in some countries. Commercial property prices tend to be more volatile and adjust more quickly than residential prices. This accelerates the impact on financial institutions. The price correction has been relatively modest compared to the past, with commercial real estate prices in the Eurozone starting to fall in 2022 and the trend continuing in the first quarter of 2023. This has led to a small improvement in rental growth, but “The adjustment has been slower than the rise in interest rates, as the yield is still below the historical spread at the risk-free rate (see Figure 1). This shows that there is still room for price changes.
Commercial real estate profits are generally closely related to the value of the properties they own, which are then used as collateral for bank loans. The increased risk of commercial real estate counterparties defaulting on their bank loans is associated with a decline in the value of the assets collateralized by these loans, increasing the extent of credit losses when banks have to repay and sell collateral.
Construction factors further reduce demand for commercial real estate in subcategories such as retail and office space. E-commerce and telecommunications have reduced demand in the retail and office sectors, while climate control has increased the cost of new construction and reduced demand for less energy-efficient existing housing. These factors have been used for some time, but their impact on profits has increased with the adoption of monetary policy.
Banks in the Eurozone, the main source of financing for commercial real estate, are exposed to financial stability risks from the sector. During the sovereign debt crisis, this risk became a reality when the concentration of mortgage loans throughout the banking system and the rapid growth of credit created by structurally flawed banking constricted the market and ultimately led to the collapse of the banks. [1]
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Commercial real estate risk in the banking system today shows the size of some countries comparable to the past, but banks are better equipped to absorb losses. Baltic banks have particularly high exposure to the commercial real estate sector, and the sector’s share of non-performing loans (NPLs) is also high (see Figure 2), although the overall ratio of NPLs in the Baltic region is low. This high level of concentration corresponds to that of Ireland and Spain 15 years ago.[2] In most countries, exposure to commercial real estate is lower. More importantly, banks today have more capital and can absorb larger losses than ever before. Overall, the capital base of banks in the euro area has doubled. Banks must also issue additional instruments that can absorb losses in a crisis. This makes a systemic crisis less likely.
Figure 2: Commercial real estate loans as a percentage of total bank loans, capital ratio A and commercial real estate as a percentage of total NPL
The quality of assets in the commercial real estate portfolio remains relatively high. NPL levels are at or below historical averages in most countries and credit losses related to commercial real estate exposures are likely to be manageable for the respective banking systems. However, the commercial real estate sector accounts for a relatively high, and in some cases growing, share of NPLs in countries with highly concentrated exposures (see Figure 3). Estonia, Ireland and Malta stand out as countries with a relatively high and rapidly growing share of NPLs.
A few banks in the euro area have very high exposure to the sector (see Figure 4). In some cases, they are systemically important banks in their home markets in terms of share of total bank assets. This is important for overall risk because problems or failures of larger banks are more likely to affect market sentiment than smaller institutions.
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Note: The y-axis shows the relative size of each bank, measured as a proportion of its assets in the total assets of the domestic industry, for a sample of 92 large banks from the euro area. Data from June 2022.
Over the past decade, mutual funds have grown to become a major source of financing for commercial real estate projects. Since 2008, the total assets under management of investment funds in the euro area that invest in real estate have more than quadrupled (see figure 5).
In the euro area, the majority of total assets are managed under open-ended fund management. Open-ended real estate funds manage assets worth around 1 trillion euros, which corresponds to 80% of total assets under management. Open-ended funds are a source of weakness for this sector due to the mismatch between liquid assets and redemption terms. This misunderstanding also creates a first-mover advantage, which can lead to spiraling foreclosures and declining property values. Fund managers have used ways to reduce this risk, i.a. Redemption and entry fee.
The increased yield of real estate investment funds could create an impact on the banking system. When a fund sells commercial real estate to finance redemptions, it can create an oversupply in the market. This makes it difficult for banks to sell foreclosed properties as collateral for defaults. Redemptions of real estate funds from the euro area have increased in recent years, but it is not high.
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Although commercial real estate poses a risk to financial stability in the current economic environment, it appears to be less of a systemic threat than in the past. Regulators and regulators have forced banks to hold more capital to absorb losses and higher liquidity needs to manage deposit outflows, along with hybrids that can shrink in a crisis. This is confirmed by the recently published results of the European Banking Authority’s 2023 stress tests, which show that European banks continue to endure a negative scenario combining a severe EU recession with a global recession.[3] In addition, commercial real estate companies are now more dependent on market-based debt financing than ever before. Bonds and commercial papers issued by commercial real estate companies are usually non-indexed and are therefore lower in demand than indexed bank loans. This means that the cost of further bankruptcies in the sector could be borne more heavily by capital market investors this time around.
The market intelligence we undertake also shows that banks have learned from previous crises and now have more conservative lending criteria. Banks now focus on cash flow and earning capacity and less on collateral. This does not mean that commercial real estate risk management and underwriting standards at banks are flawless. The European Central Bank’s commercial real estate campaign still has significant weaknesses in the areas of credit sourcing, monitoring and evaluation, among others.[4]
Although the banking sector as a whole is more resilient, banks with concentrated exposures may still be vulnerable. And banks with loans to commercial real estate companies, which also rely heavily on market-based financing, could face a difficult dilemma over whether to refinance that financing when it declines because the cost of issuing corporate bonds has risen sharply, especially for non-investments. bench. publisher. Although it violates existing loan terms, banks may be motivated to show forbearance to avoid defaults. If the loan is under stress, it can help to buy for a while, but there is also a risk that the loan will later lead to a large credit loss.
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