Source: Idealista

The refinancing difficulties of an office building in London’s City or the tense sale of the Commerzbank Tower in Frankfurt—two of Europe’s most powerful markets—are clear examples of the current turmoil in the real estate sector, marked by increased credit difficulties due to rapidly rising interest rates. According to Bloomberg, European real estate investors are facing the biggest sector cycle shift, awaiting the results from banks and their response to non-performing loans.

In the coming weeks, the extent of the situation will become clear with the year-end results from major credit institutions across Europe. Significant declines in valuations threaten to trigger loan covenant breaches, leading to emergency financing measures ranging from forced sales to cash injections.

The total amount of loans, bonds, and other debts amounting to approximately €1.9 trillion, nearly the size of the Italian economy, is secured against commercial properties and extends to owners in Europe and the UK, according to the European Banking Authority, Bayes Business School, and data collected by Bloomberg.

Approximately 20%, or around €390 billion, will mature this year, and the looming crisis marks the first real test of regulations designed after the 2008 global financial crisis to contain real estate loan risks. These rules could end up leading to an even sharper and more abrupt correction.

What Will Institutions Do with Their Problem Loans?

New regulations will pressure credit institutions across Europe to act more aggressively regarding non-performing loans. Banks and institutions are better protected than during the last real estate crisis over a decade ago, so they may be less inclined to let problems escalate.

Following the 2008 financial crisis, most banks were reluctant to claim non-performing loans, as doing so would have led to enormous losses, a practice known as “extend and pretend.” According to new rules on non-performing loans, lenders (banks and credit institutions) must account for expected losses rather than accumulated ones. This means they have fewer incentives to stay put and wait for asset values to recover.

“Year-end valuations conducted in the first quarter will be crucial,” emphasized Ravi Stickney, managing partner and head of real estate investments at Cheyne Capital, a fund manager that raised £2.5 billion for real estate loans last year. “The big question is what banks are actually going to do.”

So far, valuations have not dropped enough for senior debt—loans typically held by banks—to be in danger, but that could change soon. Commercial properties in the UK valued by real estate consultancy CBRE fell by 13% last year. The decline accelerated in the second half of the year, with a 3% drop in December alone. Goldman Sachs analysts forecast that the total decline could exceed 20%.

Banks might act before prices fall further and risk losses, forcing indebted owners into difficult alternatives. Problems could become more severe for those facing debt maturities. Banks and institutions are reducing the value of properties they are willing to finance. This means a lower appraisal could act as a double whammy, widening the financing gap.

“Bank appetite is lower and will remain so until there are signs that the market has bottomed out,” says Vincent Nobel, head of loans at Federated Hermes. “New regulations encourage banks to deal with non-performing loans, and one way to resolve the problems is to make them someone else’s problem.”

From Sweden to the Rest of Europe: Alternative Funds and Loans Might Be a Lifeline

Sweden has been at the epicenter of the crisis, with home prices expected to drop 20% from their highs. Listed real estate companies in the country have lost 30% of their value in the past 12 months, and the Swedish Central Bank and the Financial Supervisory Authority (FSA) have repeatedly warned about the risks associated with commercial real estate debt.

The decline in property values could trigger a “domino effect,” as demands for more collateral might force sales at a loss, according to Anders Kvist, senior advisor to the FSA director.

While there are some stability hotspots like Italy and Spain, which were more affected after the global financial crisis, the UK is collapsing, and there are signs that Germany could be next.

On the positive side, there are more options available for troubled real estate investors. Entities such as credit funds have expanded over the past decade. Insurers and other alternative lenders had a higher proportion of new real estate loans in the UK than the country’s major banks in the first half of last year, according to Bayes’s survey.

In the next 18 months, investors will pour a record amount of money into so-called opportunistic funds that make riskier real estate bets, said Howard Lutnick, CEO of Cantor Fitzgerald, at the World Economic Forum in Davos last week. This trend will help accelerate a recovery in commercial real estate markets, he highlighted.

These new tools could make the crisis shorter than in the past, when banks clung to non-performing loans for years. Louis Landeman, credit analyst at Danske Bank in Stockholm, expects the reset to be relatively orderly and that borrowers will have enough to take countermeasures.