US Commercial Real Estate Contagion Is Now Moving to Europe

The troubles in the US commercial property market، which have already hit banks in New York and Japan، moved to Europe this week، elevating fears about broader contagion.

The latest victim was Germany’s Deutsche Pfandbriefbank AG، which saw its bonds slump on concern about its exposure to the sector. It responded by issuing an unscheduled statement Wednesday that it had increased provisions because of the “persistent weakness of the real estate markets.” 

It described the current turmoil as the “greatest real estate crisis since the financial crisis.”

Rising interest rates

Lenders are taking increasing provisions on debt extended to property owners and developers as loans begin to sour after rising interest rates eroded the value of buildings around the world. On Tuesday، Treasury Secretary Janet Yellen said that losses in commercial real estate are a worry that will put stress on owners، but added that she thinks the problem is manageable.

For offices in the US، where the return to work following the pandemic has been slower and less substantial، the value destruction has been particularly bad. And some predict the full impact might not even be fully priced in yet. Analysts at Green Street said that a further writedown of as much as 15% may be needed this year.

“Appraisal values remain much too high،” they wrote in a note. “Lenders that base their decisions on these appraisals have greater odds of taking impairments” and some could face “strain” as a result.

The plunge in German lenders’ bonds was the latest in a series of warning signals. New York Community Bancorp was cut to junk by Moody’s Investors Service after flagging real estate problems، while Japan’s Aozora Bank recorded its first loss in 15 years due to provisions on loans extended to US commercial properties.

“There are serious concerns in the US CRE market،” said Rabobank credit strategist Paul van der Westhuizen. “It’s a not an issue for larger US and European banks but the smaller property-focused German banks are feeling a bit of pain. Right now it’s more a profitability issue than a solvency issue for them though. They have sufficient capital and are less exposed to the threat of deposit runs than pure retail banks are.”

In its results last week، Deutsche Bank AG recorded provisions for losses in US commercial real estate that were more than four times bigger than a year earlier. It warned that refinancing poses the greatest risk to the struggling sector as asset values suffer.

Elsewhere in Europe، Switzerland’s Julius Baer Group Ltd. said it would write down huge loans to bankrupt property company Signa. While it was a specific issue، it’s added to the broader worries about how far things could spread.

Bond Plunge

On Tuesday، Morgan Stanley held a call with clients recommending they sell Deutsche PBB’s senior bonds. The notes due in 2027 tanked over 5 cents after that to 97، according to CBBT data compiled by Bloomberg. Meanwhile، the bank’s AT1 notes slumped as much as 15 cents to 26 between Tuesday and Wednesday. 

Both sets of notes recouped some of their losses after Deutsche PBB said Wednesday that while it has increased loan-loss provisions to €210-215 million for the full year، it “remains profitable thanks to its financial strength.”

Sonja Forster، vice president of European Financial Institution Ratings at Morningstar DBRS، said PBB’s “focus on prime locations and relatively conservative LTVs provide some downside protection.”

“However، given that the refinancing risk is still high and fresh equity available to borrowers is limited we are monitoring the situation very closely،” she said.

Concerns over PBB has spread to other banks with CRE exposure. Aareal Bank AG bonds have lost about 10 points in the last two days and are now quoted at 76 cents on the euro. In November، it reported that the value of US non-performing loans had risen more than fourfold over the previous year.

Deutsche Bank shares were down about 3.7% as of 2:40 p.m. Frankfurt time and Commerzbank AG declined 3.2%، both underperforming the Euro Bank Stoxx Index.

Bafin، the country’s banking regulator، said it’s monitoring the situation، declining to comment on specific lenders.

The risks surrounding commercial real estate

Germany’s central bank warned last year about the risks surrounding commercial real estate، saying there could be “significant adjustments” that lead to higher defaults and credit losses. 

“The outstanding volume of loans granted by the German banking system to the US commercial real estate market is comparatively small، but relatively concentrated at individual banks،” the Bundesbank said. 

Germany’s Landesbanks have also felt the pain of their exposure to commercial real estate; in the first half of 2023، the major state banks - Helaba، BayernLB، LBBW and NordLB - posted provisions of about €400 million in total.

If the CRE losses spread to Europe through smaller German banks، that would have an echo of the 2008 global financial crisis. Back then، it was the Landesbanks that got into trouble، when their exposure to subprime mortgages in the US led to billions of euros of writedowns. 

“You have to be mindful as you don’t know exactly where the bottom is،” said Raphael Thuin، head of capital markets strategies at Tikehau Capital. “We are aware that there could be more pain to come in commercial real estate.”