Here is a brief summary of the most recent REFIRE report as they look closely at the forces at play in German real estate, and try to figure out what 2024 may have in store.
The European Central Bank (ECB) and the German central bank have both warned about the risks to the banking system posed by banks' outstanding exposure to the real estate sector. The ECB has raised concerns about the sinking commercial property sector across the eurozone that could struggle for years, posing a threat to both the banks and the investors financing it. The Bank's concerns are over a property boom which is now unravelling in countries like Germany and Sweden. Falling property prices could act as an amplifier in stress situations, heightening the risk of systemically relevant losses in the banking sector and other parts of the financial system which are heavily interlinked with the commercial property sector.
The ECB said that the number of commercial property transactions collapsed across the eurozone by 47% in the first half of this year compared to the same period last year. The largest listed landlords in the eurozone are currently trading at a discount of more than 30% to their NAVs, the biggest discount since 2008. Eurozone banks' balance sheets are indeed showing "early signs of stress" after a rise in loan defaults and late repayments from historic lows.
The ECB said that a sample of bank loans to real estate firms would suggest the recent rise in financing costs could cause the share of loans extended to loss-making firms to double to as much as 26%. This could increase to 30% if financing conditions persist for two more years, as markets expect, with firms being required to roll over all maturing loans. Even worse, 53% of loans in the sample would be to loss-making firms if those firms were to simultaneously experience a 20% drop in turnover.
The ECB also pointed out that most eurozone banks have tightened their lending criteria for residential buyers as the COVID pandemic subsided. However, the ECB sees most potential danger in commercial property, where ''policy action targeting commercial real estate (CRE) has been much more contained.'' The ECB stated that ''while the range of tools applicable at the level of banks is, in principle, identical to that of the residential real estate tool-kit, measures available to investment funds or insurance corporations are scarce.''
The ECB outlined three primary challenges, or "headwinds," for banks' profitability. These include heightened funding costs as banks pass on increased rates to depositors, a rise in loan defaults due to economic weakening and higher debt service costs, and an escalation of the conflict in the Middle East, which could act as a catalyst, triggering a sharp increase in risk aversion in financial markets.
The ECB's Financial Stability Report emphasized that the banking system is "well placed" to cope with a deterioration in asset quality, bolstered by its "strong capital and liquidity levels" and buoyant profitability, recently hitting its highest level for more than ten years. Only 10% of banks' total loan books are attributable to commercial property, with 30% exposed to residential property. However, banks' outstanding exposure to the real estate sector is a significant threat, and the ECB believes that a comprehensive policy response for CRE markets is required to target all exposed actors and avoid leakages and would need to take particular care to avoid procyclicality.
ECB vice-president Luis de Guindos emphasized that while there may be a perception of reduced immediate risks to financial stability, they still remain at "elevated levels." He pointed to the potential impact of factors such as weakened economic growth, tighter financing conditions, increased loan defaults, and a further downturn in property markets.
This article is a brief summary of the REFIRE 2023 report. Please reed the full report here.
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