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Wholesale Banking

Let's talk real estate : why can't banks catch a break?

The softness in the commercial real estate market is not a concern of the past yet. Nordic banks remain most exposed to the CRE sector, but when it comes to climate change transition risks, these assets do not appear to be among the most vulnerable in Europe.

A cluster of apartment complexes in a city

 Although rental income growth remains stable, real estate investment volumes are declining, and concerns remain over tougher financing conditions and high CRE debt maturities. However, banks are better capitalized now, and supervisors remain alert as interest rate levels stay high in an uncertain geopolitical, inflationary, and economic environment.

The worst price declines appear to be over in Commercial Real Estate

While Nordic banks have significant exposure to the CRE sector, with Sweden and Denmark having the highest exposures, the performance of CRE loans from Nordic banks remains solid, with low non-performing loan ratios. In contrast, banks from Poland, Estonia, Portugal, and Ireland have the highest CRE non-performing loans. To improve bank capitalisation levels, the Systemic Risk Council in Denmark recommends introducing a 7% sector-specific systemic risk buffer for bank exposures to real estate companies from 30 June 2024.

Property price developments matter for CRE collateralised loans

Collateralised loans are an important security against non-performing loans in the commercial real estate sector. Benelux banks have a relatively prominent position in the corporate loan books secured by CRE, and banks with higher exposure to CRE firms have relatively higher shares of CRE collateralised loans. The decline in the value of commercial real estate collateral can worsen loan recovery prospects and impact banks beyond their direct exposures to CRE firms. With rising corporate default rates, the collateral value of commercial real estate becomes crucial even for banks with less direct exposure to CRE companies.

Real estate valuations may overestimate true value

Real estate collateral or financial guarantees lead to lower credit risk loans. However, if the collateral value decreases, loan performance can worsen, causing impairments. This affects banks that rely heavily on real estate collateral. Collateral valuation risks have emerged as a top priority for the European Central Bank (ECB) in commercial real estate loans that have low loan-to-value ratios. Banks may need to make aggressive valuation adjustments on their collateral, leading to provisions rising if certain LTV covenants are breached. Moreover, defaulting corporate counterparts may cause commercial real estate collateral values to decrease, resulting in reduced loan recovery prospects.

The impact of climate change on commercial real estate assets

Climate change poses risks to the commercial real estate market. Physical climate risks like floods, storms, and wildfires can cause severe damage to properties. Energy-inefficient buildings can lose value due to higher energy consumption costs and not meeting energy performance targets. European banks have reported on climate risk metrics for commercial real estate activities and collateralised loans since 2022, with substantial reporting differences. The physical climate risk assessment differs widely among banks, with Finnish and Estonian banks at the extremes.

European banks' CRE sector exposures will expire within five years, which is positive from a transition risk point of view. Shorter maturities provide banks an opportunity to renegotiate loan terms for stricter environmental requirements, supporting decarbonisation targets. Danish banks' commercial real estate exposures appear more sensitive to transition risks as loan maturities mostly stretch beyond five years. Banks disclose the energy performance of their commercial real estate assets using energy performance certificates (EPC) labels and scores. However, EPC labels have poor data availability in most countries.

Energy performance scores provide a better idea of the transition risk exposures of commercial real estate collateral

Banks with EPC labels tend to disclose a higher percentage of loans in the less energy-efficient EPC label E, F, and G buckets, which are most exposed to transition risks. The lack of comparability of EPC label definitions makes it difficult to draw conclusions. The energy performance scores may give a better idea of the transition risk exposures of commercial real estate collateral. While these scores are still largely based on estimates, they do cover the full commercial real estate collateralised loan portfolio and are better comparable in terms of actual energy demand. These energy performance scores identify CRE properties in Portugal and Ireland to be more sensitive to transition risks.

In conclusion, the concerns in commercial real estate for banks are driven by rising interest rates, declining demand for office space, and climate change risks. While Nordic banks are most exposed to the CRE sector, they have solid CRE loan performance, with low non-performing loan ratios.

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