Turmoil in trophy properties in London and Frankfurt offers a glimpse of the damage in store for European property investors as they face the sharpest turnaround on record.
From a grueling refinancing process for an office building in the City of London to the grueling sale of the Commerzbank Tower in Germany’s financial center, investors struggle to find ways to bridge funding gaps as credit markets are bogged down by rapidly rising interest rates.
The reality check will begin to hit in the coming weeks as lenders across Europe get the results of year-end assessments. Sharp falls in valuations threaten to lead to loan covenant violations, triggering emergency financing measures, from forced sales to pumping in fresh cash.
“Europe is going through the great relaxation of 10 years of easy money,” said Skardon Baker, a partner at private equity firm Apollo Global Management. “The amount of suffering and disruption is off the spectrum.”
Loans, bonds and other debts totaling about €1.9 trillion ($2.1 trillion) — nearly the size of Italy’s economy — have been backed by commercial property or issued to landlords in Europe and the UK, according to the European Banking Authority , a study by Bayes Business School and data collected by Bloomberg.
Roughly 20% of that, or about €390 billion, will mature this year, and the looming crisis marks the first real test of regulation designed after the global financial crisis to curb real estate lending risks. Those rules could make a correction steeper and more abrupt.
The Commerzbank Tower in Frankfurt, Germany. Photo credit: Alex Kraus/Bloomberg
“I think the revaluation will be faster than in the past,” said John O’Driscoll, head of the Real Assets division of French insurer Axa SA’s investment management unit. “People start to be exposed as the tide goes out.”
European lenders will be urged by the new regulations to be more aggressive against bad loans. They are also in better shape than they were during the last real estate crisis more than a decade ago, and so may be less inclined to let problems fester. That puts the burden on the borrowers.
Rules of the game
What changed
Why it matters
Banks must make provisions for expected, rather than accrued, losses
No more “extend and pretend”
Loans with breaches of covenant entail a higher cost of capital
Incentivizes banks to act faster on bad loans
German private investors have to wait up to a year for repayments from real estate funds
Ensures a more orderly sale of assets
French real estate funds must hold at least 25% of the funds in cash or shares
Provides liquidity buffer
In the aftermath of the 2008 financial crisis, most banks were reluctant to take on bad loans as it would have resulted in huge losses – a practice called “expanding and pretending”. Under new rules on non-performing loans, lenders will have to make provisions for expected rather than accrued losses. That means they are less likely to sit still and hope that asset values will recover.
“The year-end valuations in the first quarter will be crucial,” said Ravi Stickney, managing partner and chief investment officer for real estate at Cheyne Capital, an alternative investment fund manager that raised £2.5 billion in real estate loans last year. “The question mark is what the banks actually do.”
Coping Strategies
Some recent deals show how real estate companies are responding to the end of the easy money era, but forced sales are the exception rather than the rule for now.
1 portsoken street
Owners of an office building on the edge of London’s insurance district failed to secure refinancing before some £140 million ($174 million) of debt matured in July, leading it to include a material uncertainty clause in its accounts issued in August were submitted.
Although the modernized and partially leased building was valued at around £220 million in February 2022, values have since fallen. For the remaining space, both refinancing and lease discussions are underway that could provide a solution. Without progress, the result could be a forced sale.
One poultry
The Korean owners of the building near the Bank of England extended shareholder credit after a fall in value led to a breach of a Bank of Ireland loan, according to company accounts. The strategy obviously requires owners to have cash available, which is not the case for many highly indebted European landlords. React News previously reported the missed refinancing TBEN.
Opel construction
In London, Guangzhou R&F Properties Co. an alternative to bank loans. The Chinese developer turned to a consortium with Apollo Global Management Inc. and Carlyle Group to secure £772m of senior and mezzanine debt to resume work on an apartment and hotel complex in Vauxhall.
Commerzbank Tower
In Frankfurt, another Korean investor chose to try to sell the tower occupied by Commerzbank AG instead of trying to refinance. That is a rare step in today’s market. According to Chris Staveley, head of international capital markets in Europe for JLL, about €20 billion in planned office sales in Europe was pulled last year as sellers heeded falling values.
Senior debt ratings
So far, valuations have not fallen enough for senior debt – the loans typically held by banks – to be underwater, but that could soon change. By CBRE Group Inc. valued commercial property in the UK fell 13% last year. The decline accelerated in the second half, with the broker recording a 3% decline in December alone. Analysts from Goldman Sachs Group Inc. have predicted that the overall decline could exceed 20%.
Banks can then act before prices fall further and risk credit losses, forcing indebted landlords into difficult alternatives. The problems become more thorny for those dealing with debt. Lenders reduce the amount of a property’s value they are willing to lend. That means a lower rating could be a double whammy, widening the funding gap.
“Banks’ appetite is lower and will continue to be lower” until there are signs that the market has bottomed, said Vincent Nobel, head of asset-based lending at Federated Hermes Inc. The new regulations urge banks to deal with bad loans “and one way to solve problems is to make it someone else’s problem.”
Sweden has been the epicenter of the crisis so far, with house prices expected to fall by 20% from peak levels. The country’s listed real estate companies have lost 30% of their value in the past 12 months, and Sweden’s central bank and financial supervisory authority have repeatedly warned of the risks posed by commercial real estate debt.
According to Anders Kvist, a senior advisor to the director of the FSA, declining property values could create a “domino effect” as the demand for more collateral could force a forced sale.
While there is some stability, such as in Italy and Spain, which were hit harder after the global financial crisis, the UK is slumping and there are signs that Germany could be next.
On the bright side, there are more options available to investors in tied real estate. Entities such as closed-end credit funds have grown steadily over the past decade. Collectively, insurers and other alternative lenders had a higher share of new property loans in the UK than the country’s largest banks in the first half of last year, according to the Bayes survey.
Over the next 18 months, investors will pour a record amount into so-called opportunistic funds that take on riskier real estate bets, Cantor Fitzgerald CEO Howard Lutnick said at the World Economic Forum in Davos last week. The trend will help accelerate an upswing in commercial real estate markets, he said.
These new tools could make the turmoil shorter than in the past, when banks held onto bad loans for years. Louis Landeman, a credit analyst at Danske Bank in Stockholm, expects the reset to be relatively orderly and that borrowers will have enough to take countermeasures.
“Anyone who can come up with a creative way to fill that gap is going to have a great time,” said Mat Oakley, head of commercial research at Savills.
–With assistance from Anton Wilen, Antonio Vanuzzo, Damian Shepherd, Konrad Krasuski, and Nicholas Comfort.
Lukasz Finance 