Covid-19 is just the latest challenge for European real estate lenders

Although the property sector has created new challenges for banks during the current crisis, these institutions were already contending with larger pressures beforehand.

The coronavirus pandemic has delivered a fresh hit to European banks at a time when some are still dealing with the legacy of the 2008 financial crash.

By increasing their capital positions and complying with stiff regulation, the continent’s lenders have been able to enter this crisis with far lower leverage levels, better-quality real estate exposure and a greater spread of risk than was the case at the start of the previous downturn. However, banks are grappling with a host of emerging issues, such as loan defaults, covenant breaches and covenant waivers, as well as an expected surge in non-performing loans.

And despite their relatively healthy and stable positions, European banks are still tackling issues resulting from the global financial crisis, as we report in our summer 2020 edition, published this week. One of the main issues is the level of bad loans. According to the European Banking Authority, the weighted average NPL ratio for the continent’s lenders fell from 6 percent in 2015 to 3 percent as of June 2019, with total NPLs in the eurozone’s biggest 121 banks dropping by more than 50 percent to €506 billion by the end of 2019. That said, Greek, Cypriot, Portuguese and Italian banks still have NPL ratios above 6 percent.

Moreover, NPLs could start piling up on banks’ balance sheets as borrowers face greater difficulty collecting rent as the slowdown puts pressure on tenants. Cass Business School’s UK Commercial Real Estate Lending Report forecasts loan write-offs and debt losses for the retail sector of up to £10 billion (€11 billion).

Another challenge for European banks has been the latest round of regulation from the Basel Committee for Banking Supervision. Although the regulation, known as ‘Basel IV’, is intended to standardise banks’ calculation of risk-weighted assets, it does so by requiring lenders to increase their capital reserves, which places upward pressure on margins.

New accounting rules under IFRS 9 were also introduced post-GFC, which forced lenders to set aside provisions for bad loans at an earlier date. Recognising that this requirement could impair capital buffers and crimp banks’ ability to lend as covid-19 brought Europe to a halt, the EBA and the UK’s Prudential Regulation Authority tried to soften the impact in late March by relaxing accountancy requirements.

Lastly, Europe’s banks were already facing additional pressure on revenues before the crisis as a result of weaker GDP growth and continued low interest rates – with the latter putting extra pressure on profits generated from lending, as Fitch Ratings noted in a December 2019 report. At the time, Fitch said the average common equity tier one ratio, which measures banks’ equity versus risk-weighted assets, was down year-on-year from 14 percent to 13.7 percent.

According to a McKinsey report, Europe’s banks could now see their common equity tier one ratios fall to as low as 8 percent, compared with 12-13 percent at the start of the crisis.

The heightened risk environment means European real estate lenders will be taking an even more conservative approach. Market participants say a surge in NPLs would lead lenders to focus less on underwriting new credit and instead concentrate on managing their existing loan books and working with clients to address any potential breaches.

Meanwhile, loan-to-value ratios for new lending facilities could lower further. One debt advisor told Real Estate Capital that whereas banks were previously lending at an average LTV of 70 percent, the figure would now be 60 percent.

There is no doubt real estate will remain a critical business for many of Europe’s banks. However, financing activity in the continent’s property sector will be altered due to the mounting pressures lenders are now facing.

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