German multifamily loans are “particularly sensitive” to the risk of default owing to low debt yields in the sector and strict rental controls making it difficult for landlords to offset rising interest rate costs, according to credit rating agency Moody’s.
It said on 5 April that the risk of default both during the term of existing loans and at the point sponsors need to refinance has risen in recent months because of borrowers’ “weakening affordability” and declining values for multifamily property.
“This is credit negative for German banks, covered bonds, real estate companies and CMBS with exposures to multifamily property,” Moody’s said.
The London-based credit rating agency added that the five Germany multifamily property companies it rates – Vonovia, Grand City, LEG, TAG and Peach Property Group – were facing pressure from higher debt costs: “The marginal cost of debt for nearly all of these companies is now above portfolio yields and they reported property value declines of between 1 percent and 5 percent over the second half of the 2022 fiscal year.”
Nearly all of them, Moody’s added, had communicated reduced capital expenditure and disposal plans to bring down debt.
Low debt yields
In recent years, lenders have provided higher leverage when financing German multifamily properties, compared with other commercial real estate assets, because multifamily assets typically generate stable cashflows and are in high demand from tenants.
However, multifamily rents, which are controlled and capped for both new and existing tenants, result in low debt service coverage ratios, making that cashflow less able to cover any rise in interest rates and operational costs.
In the note, Moody’s outlined metrics of a typical multifamily deal in 2021, stating that a property with an annual net rental income of €1 million would have been bought at a cap rate of 2.2 percent, and financed with a loan of up to 70 percent.
The debt yield generated by this level of rental income would have been around 3.1 percent – significantly lower than for shopping centres, which in the same year would have typically had a debt yield of 8.3 percent, it said.
Rising interest rates since 2022, which increased in the eurozone to 3 percent in March, will have depressed those debt yields further, impacting borrowers with unhedged, variable-rate interest costs most, Moody’s said. These sponsors, it explained, are “therefore more likely to default on payments during the term of the loan”.
Moody’s added: “More significantly, multifamily borrowers will generally find it harder to obtain funding to replace maturing loans, increasing refinancing default risks.”
“As risks increase, so too will the likelihood that commercial real estate sponsors will have to provide additional equity to refinance their loans, or default and lose control of their investments,” it concluded.
German banks, it added, had “significant exposure” to loans backed by multifamily, adding: “We expect banks’ risk provisioning costs for multifamily property will rise from extremely low levels. The rising provisioning needs, in additional to higher operating and refinancing costs, will pressure banks’ profitability.”
Moody’s also highlighted exposure to the sector in the German covered bonds sector. Covered bonds – debt securities issued by banks and institutions backed by a group of assets – tended to have exposure of between 20 to 30 percent to multifamily on average in Germany, Moody’s explained.