Escalation of bank sector problems cannot be ruled out, says M&G

While recent banking sector turmoil currently looks unlikely to turn into a full-scale financial crisis, stresses in the system still threaten commercial property markets, M&G Investments has warned in its Global Real Estate Mid-Year View report.

The UK manager said further banking sector issues could yet flare up, most notably within mid-tier US banks, which have outsized commercial real estate exposure.

“The current situation is not like the global financial crisis, but we are not out of the woods, and there is a lot of uncertainty,” José Pellicer, head of investment strategy at M&G Real Estate, told Real Estate Capital Europe. “We don’t know whether we are in the calm after, or before, the storm.

“If the US banking crisis gets worse, it will affect Europe. It will dent sentiment in terms of lenders providing new loans and in terms of credit conditions. It would affect liquidity in general,” he added.

Pellicer believes “second order effects” of further problems in the US banking system would impact European markets, despite Europe’s banks being generally well provisioned. “We could see a tightening in non-bank lending in Europe. If that were coupled with recession, that causes problems,” he said.

M&G argued the banking system is in a relatively solid position, due to less risky lending and more regulation than in the years preceding the GFC. The swift response from policymakers to banking issues in March has also reassured markets and reduced contagion risk. However, M&G said: “Confidence can be a fragile thing, so escalation into a full banking/financial crisis still cannot be ruled out.”

On mid-sized US banks, it added: “Following a loosening of regulation for mid-sized banks in 2018, the scrutiny on many of these banks is more limited – and so the full extent of the risk is unknown.”

Credit conditions

Tighter credit conditions for real estate markets can be expected for the foreseeable future, M&G warned, negatively impacting valuations and transactional activity. Secondaries assets will be hardest hit, with sustainability upgrade plans likely to be put back.

Overall, M&G expects a further correction in real estate prices, as ‘second order effects’ weigh on market fundamentals and transactions. It cited the US office sector, with record-high vacancy rates, as a major example.

However, Pellicer sees potential for stress in Europe. “Highly leveraged loans on low-yielding assets, of the type that have been fashionable in recent years – Berlin offices spring to mind – will have been impacted by interest rate rises. Going forward, many such assets will have problems occupationally.”

Refinancing risk is a concern, exacerbated by tightened credit conditions, he added: “If you borrowed at 2.5 percent in 2018 and now need to refinance, you will be doing so at a cost of 5-7 percent, and with tighter LTVs. If the borrower does not have additional capital to put in, it may trigger a sale.”

In the report, M&G highlighted the potential for distress, including the possibility of forced sales. While distress has not yet been seen widely, Pellicer believes a recession would trigger forced sales as banks become concerned about income.

Alternative lenders are not immune to the stresses of higher rates, M&G added in the report, particularly those which have lent to higher LTVs in recent years, or against non-core assets.

For Pellicer, the non-bank lending sector is a risk. “Banks have been heavily regulated, so they did not overexpose themselves. However, some of the non-banks filled the financing gap, at higher leverage, and it is a less transparent part of the market.”

Close to the peak

The peak of interest rate rises could be close, with rate cuts even possible this year, M&G said. “Central bankers have a trade-off: do they favour financial stability over taming inflation? They may swallow higher inflation for a period so they can have financial stability,” Pellicer explained.

M&G said the outlook for real estate markets varies by geography, with vulnerabilities most apparent in the US. The UK has seen the fastest correction, it added, but it warned higher mortgage rates have yet to fully hit households, bringing into question the country’s potential for economic recovery. “The potential for further banking volatility poses risks that should not be ignored,” it added.

Overall, while M&G said economic performance has surprised to the upside in Europe to date, downside risks – including a protracted or deep recession – remain real. Pellicer identified the eurozone entering a period of near zero growth, with GDP falling 0.1 percent in both Q1 2023 and Q4 2022. He added stressed European economies are likely to continue feeling the pinch over the coming quarters.