Do America’s problems spell trouble for European real estate debt markets?

The adage about America sneezing and the rest of the world catching a cold is pertinent for real estate financing markets right now.

A steady stream of headlines since March indicate that the US banking and commercial real estate sectors are displaying signs of sickness. For some in European real estate markets, there is a growing sense of unease about all things finance and property from across the Atlantic.

But how concerned should Europe’s sector professionals be? Is a real estate debt crisis brewing across the Atlantic, and is there a danger of contagion for Europe?

Two main factors encourage speculation. First, the failure of three regional US lenders, beginning in March with California’s Silicon Valley Bank, has prompted discourse on the availability of financing for commercial real estate, and the potential for wider financial sector instability.

Second, worries are growing about US lenders’ exposure to the country’s office sector due to high levels of vacancy since the covid-19 pandemic. With a mountain of near-term debt maturities facing lenders, many expect to see defaults.

European credit analysts at US banking giant JPMorgan – in a March paper entitled ‘Europe versus US: CRE and banking sectors’ – argued that while both US and European banks are dealing with the challenges posed by rising interest rates, the outlook is sunnier for Europe.

The analysts argued that deposit outflows from regional banks to money centre banks in the US are impacting liquidity, reducing smaller lenders’ ability to fund commercial property borrowers, as well as their ability to ‘amend and extend’ existing loans in a bid to protect underlying asset value. This, they warned, potentially creates a “negative feedback loop for banks in terms of asset quality”.

However, the US Federal Reserve, in its Financial Stability Report in May, concluded that the country’s banking system remained “resilient, with substantial loss-absorbing capacity”. Poor risk management undermined certain banks, it said, while the broader system remained sound.

There are voices within the US commercial real estate financing sector urging perspective on the country’s issues. Scott A Singer, principal and co-lead of Avison Young’s tri-state debt and equity finance team, based in New York, argues there is neither a crisis in US banking nor in real estate. While he acknowledges problems, he disagrees they are, or will become, systemic.

“In the US, the headlines and the on-the-ground reality are very different,” he argues. Singer says the commercial real estate sector is being unfairly labelled as universally troubled due to challenges in the office sector. “We see a huge diversity of situations. My team at Avison Young is in the market right now with $1.5 billion of debt transactions, and we have offers on all, ranging from development to stabilised properties across all sectors.”

Singer argues that there is an abundance of capital to fund US real estate. “Even with a pullback [from regional banks], we don’t have a liquidity crisis. We have challenges in the system that are being dealt with. If there’s a pullback in one sector, other sources view it as an opportunity.”

Singer cites the competition from a wide variety of sources beyond regional banks as evidence of a continuation of a functioning commercial real estate credit market. “There are banks that fail in the US every year. The reason there are such worries now is because new tech exists, and people can withdraw funds quickly. But the way the Fed stepped in to inject confidence into the market sent a message: if you invest in a bank’s stocks and bonds, you are taking a risk. But if you have money deposited in a bank, you are not.”

In a report published in April, Rich Hill, head of real estate strategy and research at US manager Cohen & Steers, argued that banking sector stress is not a systemic commercial real estate debt problem.

“We anticipate increases in delinquencies and distressed sales, but the risk of loss to CRE lenders may be smaller than many believe,” Hill wrote. “Lending standards are more conservative than before the [global financial crisis], with loan-to-values of 50-60 percent and debt service coverage ratios of more than 2.0x. CRE property prices would need to fall 40-50 percent before the loans would realise losses.”

“We anticipate increases in delinquencies and distressed sales, but the risk of loss to CRE lenders may be smaller than many believe”

Rich Hill
Cohen & Steers

The US commercial real estate mortgage market, Hill wrote, is in the order of $4.5 trillion, backed by income-producing assets and $470 billion of construction loans. Banks hold around 45 percent of commercial mortgages, with the 25 largest accounting for 13 percent, representing 4 percent of their assets. Regional and community banks hold 31.5 percent, accounting for 20 percent of their assets. Offices, he added, account for 17 percent of income-producing loans, whereas multifamily accounts for 44 percent.

Hill acknowledged that there will be some restructurings and foreclosures, with borrowers required to inject equity. “Bottom line: we view this as primarily an equity problem for some property types, but it is not a debt problem.”

View from Europe

The extent of the problems facing US commercial real estate lenders remains unknown. In Europe, there are real estate finance specialists who say the plight of the US sector is not at the forefront of their minds, at a time when rising rates and a correction in capital values are demanding their attention.

Christian Schmid is a member of the board at German bank Helaba, with responsibility for divisions including real estate finance and asset finance. “I am sure the failure of SVB, and rescue of Credit Suisse, prompted the whole industry to analyse what impact this might have,” he says.

However, Schmid does not currently see evidence that these events, including regional bank failures, are part of the onset of a wider banking sector crisis. “From my point of view, we are just seeing individual problems or issues,” he says. “I don’t see it being part of a wider picture at the moment.”

JPMorgan’s credit analysts said in their report that deposits continue to flow into European banks to a greater extent than US banks, ensuring more liquidity. The analysts added that European regulators’ framework, the Bank Recovery and Resolution Directive, which enables ‘going concern’ resolutions for troubled banks, rather than allowing them to fail if they aren’t bought privately, also shores up confidence.

“The fact that we often expect what happens in the US today to happen here tomorrow can be self-fulfilling”

Peter Cosmetatos
CREFC Europe

The analysts added: “Fundamentally, we believe that any contagion from either US banks or US CRE onto European peers is not justified, given different sector dynamics.”

The US and European banking sectors have important points of difference, agrees Schmid. “The US banking sector has much more of a capital markets orientation than we have in Europe. Of course, we have a stock-listed banking sector. But in Germany, we have several pillars of banking – private banks, stock-listed banks, savings banks, and people’s banks. This provides stability.”

Schmid argues European banks are managing risk closely. “The capital markets model means, if you want to raise money on the stock exchange, you need to be an attractive investment, and that comes through profitability. In Europe, we have a stable income base that allows for a lower return, but a stable return.”

Pierre Semeria, head of asset finance for the EMEA region at BNP Paribas, says the French bank has limited activity in the US commercial property market.

However, he keeps a close eye on events across the Atlantic. “The regional banks, the most exposed to the commercial real estate – and mainly office – market difficulties, are less regulated than we are in Europe. But the large US banks do not seem to be affected. In addition, European banks like us have increased their capital a lot in the past 10 years, so there is a significant safety net.”

Semeria believes that speculation about the health of the US property markets is among factors feeding hesitancy among property investors, including in Europe. “The US just creates an extra level of uncertainty. We’ve seen some cautiousness on offices because of the current trends we are seeing in Europe, but the much more concerning situation of the US office market does have an additional impact on investors’ assessment. Generally speaking, the market is in waiting mode and we hear some investors will pause until the end of the year.”

Peter Cosmetatos, chief executive of industry association CREFC Europe, argues that “noisy background” in the form of negative press sentiment towards the US commercial property market has the potential to affect European markets.

He acknowledges genuine areas of concern, but argues there is a risk of people conflating and extrapolating from two distinct issues: US regional bank failures and the struggling US office sector. “I don’t see a direct implication for European real estate lending of the regional bank failures. But the tendency to link US regional bank stress to the weakness in – mainly gateway city – offices increases the general negativity about real estate. That, in turn, may cause US capital, which is a big part of the mix in real estate and credit markets here, to pull back. In addition, the fact that we often expect what happens in the US today to happen here tomorrow can be self-fulfilling.”

Specifically on the office sector, while he believes America’s workplace problem “seems to be much more acute”, he warns against underestimating the impact of more remote working on European markets. “Parts of the market here are in denial about changing office use and maybe are not pricing in enough of that change,” he says.

Voicing concerns

Fears of a financial crisis seem to have passed, for now. But within the real estate investment market, many believe the global nature of capital flows inevitably means the fortunes of the US and European markets will be, to a degree, linked. While some senior figures in the real estate investment industry admit to concerns about the US, they are also quick to offer reasons Europe will likely be insulated.

Speaking at the PERE Europe Forum in London in May, hosted by Real Estate Capital Europe’s affiliate title PERE, Nathalie Palladitcheff, chief executive officer of Ivanhoé Cambridge, the Montreal-based property manager of institutional investor Caisse de dépôt et placement du Québec, gave her view: “I’ve spent a lot of time in the US over the last weeks and I can tell you that, from the US standpoint, it’s a real estate crisis which is impacting the financing market but not the other way around,” she said.

Palladitcheff added that she heeded the warning of a Federal Reserve economist who suggested we may be “between Bear Stearns and Lehman Brothers”, in a call-back to how the 2007 crisis played out. “Just after Bear Stearns, we had a kind of ‘it’s OK, it’s under control, nothing’s going to happen, we’re not going to have any contagion’ [moment]”, before a crisis did occur, she said.

“Policymakers have… been swift and robust in their remit to maintain financial stability, signalling that bank deposits will be guaranteed”

Tony Brown
M&G Real Estate

“My feeling is the summer is going to be key. And if you add to that the geopolitical risks that we have to face right now, which is an ingredient [that is] different from 2008, where all the countries around the world were aligned to find a solution, I don’t think it is going to be the same this time.”

Warnings of stress in the banking system have prompted leaders at major real estate investment institutions to analyse the financing market. Among them is Daniel McHugh, chief investment officer for the real assets division of UK manager Aviva Investors. “Maturity dates in the US are nearer-term than in the UK or continental Europe. The vast majority are 2024-25,” he says. “If there is going to be an issue in terms of refinancing, bank appetite, or potential distress in bank loan books, it is going to happen sooner rather than later in the US.

“In Europe, maturities peak in 2025-26. Our sense is also, because of the regulatory situation in Europe, banks are likely to be less indebted, and it will be less of an issue. If [banking sector issues] do occur, they will tend to be isolated or specific as opposed to widespread. That’s our reading of the situation.”

McHugh’s view is that some of the negative commentary around the US banking system – including Trump-era deregulation, the scale of regional property lending, and the volume of near-term maturities – may be merited. “The one mitigant I would add is that the US real estate market is more used to an elevated interest rate environment, so you could argue they might be a bit more resilient. In continental Europe, we’re coming off the lowest rate environment we have ever seen so the incremental change to the cost of debt is not marginal, it’s multiple.”

For Tony Brown, global head of manager M&G Real Estate, the steep rise in rates after a decade of cheap financing made financial sector repercussions inevitable. Writing for PERE in May, he acknowledged this has manifested itself among smaller US banks. He added there is “a clear sense of risk in the wider banking sector owing to interest rate rises, a fall in the value of banks’ asset bases and depositor nervousness”.

But Brown also wrote that there is good reason to believe banking sector turmoil will be contained, including an absence in recent years of the risky lending that preceded the 2007-08 financial crisis. He is among those that have taken solace in how regulators responded to issues in the US and Europe.

“Policymakers have… been swift and robust in their remit to maintain financial stability, signalling that bank deposits will be guaranteed. This support has helped to reassure markets and may already be preventing contagion,” he wrote.

Big trends

Some among the industry’s research and strategy specialists also strike a measured note. Sabina Reeves, chief economist at manager CBRE Investment Management, based in London, does not expect to see bank failures in Europe any time soon. “The managed takeover of Credit Suisse made people nervous, but they shouldn’t be overly concerned. We believe we are not at the start of a global systemic failure in banking of the type seen in 2008.”

Europe’s banking system is structured differently to the US, she says. “The US has an enormous tail of smaller banks. We have a more consolidated system here, with fewer banks per capita, and they are in a better position in terms of capital provisions. It’s also important to note how quickly regulators stepped in – both here in Europe and in the US with SVB.”

The tightening of credit in European markets, Reeves adds, stems from 2022’s rapid interest rate increases rather than more recent uncertainty in the banking sector. “The more dominant thing now is what happens with rates going forward. People thought a US recession may be happening and the Fed would reduce rates. But that has not happened yet, and the ECB has kept a hawkish tone. In Europe, the real driver of sentiment is perceptions about what the ECB will do next.”

Justin Curlow, global head of research and strategy at Paris-headquartered manager AXA IM Alts, has considered whether problems in the US commercial property market portend problems in Europe. He is not convinced this is the case. “Is there a crisis with widespread defaults in Europe? No. Are there looming defaults in the US? Probably. But it is nuanced because it is mainly centred on the office sector,” he explains.

“The function of offices is very different in the US and Europe. Americans have big homes and very good internet connectivity, so it is easy for them to work from home. Also, many drive to work, and the price of gas is up, so they are financially incentivised not to commute. The job market is strong, giving them the negotiating leverage to ask to work from home.

“That behavioural nuance is specific to the US. While European and Asia-Pacific offices are back to 60 to 70 percent utilisation, the figures are 50-60 percent at best in the US.”

Curlow also points out that landlords’ exposure to tech tenants is far larger in the US than in Europe. “A lot of expansion space has been put onto the sublease market. There is some in Europe, but nowhere near the amount that could disrupt market fundamentals. In the US, the overall office vacancy rate is north of 17 percent, where Europe is a much more normal 6-8 percent, with grade A tight in many cities.”

Pending problems

Events have a habit of moving quickly in financial markets but the consensus view at the time of publication is that a GFC-style financial meltdown, stemming from the US regional banking sector, is not on the cards.

However, real estate professionals are not sanguine about the challenges facing US lenders when it comes to commercial property exposure – especially offices.

More generally, there is a sense of disquiet within the finance part of the European property industry, around the defining topic of the day – the unpredictable rise of interest rates. The problems in US regional banks, and lenders’ exposure to falling asset values, all link back to varying degrees to the shock of rising interest rates in 2022 following more than a decade of cheap debt.

Many agree the correction in property prices driven by rising rates will test the portfolios of Europe’s banks. Macroeconomic concerns about recession, financial sector stability, and the strength of the US property sector, just add layers to the uncertainty.

Against this backdrop, however, plenty in the industry see ripe conditions for issuing fresh debt. AXA IM Alts’ Curlow is among those who see a huge opportunity for non-bank lenders to provide debt capital at attractive returns.

“At inflection points in the cycle, debt investments make most sense,” he explains. “Loan sizes relative to peak values are much lower given more modest loan-to-value ratios, and pricing margins wider.”

Concerns about the US might be on peoples’ minds in Europe. But so is the challenge of managing loan books in a rising rate environment, and the prospect of writing new loans in a disjointed lending market.