Some German bankers argue that loan margins are reaching a floor, although few can guess when they will rise, writes Daniel Cunningham.
German real estate lending margins have become wafer thin. During the first quarter of this year, pricing was noted as low as 80 basis points over three-month Euribor, with some whispering that business had been done even lower.
Margins have been squeezed even further since then, with deals priced as low as 60 bps. Such transactions do not reflect the bulk of the market, bankers protest, but the point is that the German real estate finance sector remains ultra-competitive.
“Pricing has gone as low as it can get,” comments Björn Kunde, head of debt advisory in Germany for Savills. “Even at these rates it is challenging to be profitable for banks.”
Investors are putting equity to work in their deals, meaning that there is little upward pressure on loan-to-value ratios, which remain conservative. Germany’s mortgage banks are therefore forced to compete for the country’s prime financing opportunities on price. Their cost of funding remains very low, as a result of their access to the Pfandbriefe covered bond market. In March, Berlin Hyp even issued a Pfandbrief with a negative yield and zero percent coupon. In short, borrowers have become used to a steady supply of cheap finance.
It is not a sustainable situation, bankers argue, with some suggesting that loan pricing is bottoming out. The major force pushing against the downward margin pressure is the banks’ anticipation of increased regulatory requirements on their capital.
There is little clarity on the outcome of the Basel Committee on Banking Supervision’s latest revisions to the 2010 Basel III accord. However, many expect that the committee will no longer recognise the use of internal ratings-based (IRB) models of allocating risk-weighting in real estate lending. For German banks, which typically use internally-devised models, it means that loans could be bucketed in categories which could require greater risk-weighting and therefore increase their capital costs.
“I expect that pricing is reaching a floor,” says Michael Kröger, international head of real estate finance at Helaba. “Increased regulatory requirements are already in sight and I doubt that non-bank lenders will be prepared to take these low-margin positions when banks need to increase their pricing. The regulatory requirements on capital for banks have increased and will increase further.”
If margins have indeed reached a floor, few are prepared to guess when they might begin to rise. With the summer slowdown almost upon us, it is difficult to see a significant shift in pricing occurring between September and the end of 2016.
“Pricing in the UK bottomed out prior to the EU referendum announcement, and it has gone up in Scandinavia due to regulatory pressures. Pricing is also up in Poland. The German market will not go on as it is. We will see pricing rise, but we do not yet know when that transitional phase will happen or what it will mean for the market. It could possibly mean fewer lenders,” adds Kröger.
Pbb Deutsche Pfandbriefbank (pbb), which was Germany’s most prolific lender last year with €10.4 billion of business, has stated its aim to maintain margins on new loans in 2016 at the previous year’s levels “to the extent possible”.
Gerhard Meitinger, head of real estate finance Germany at pbb argues that his bank would rather pass on a deal than accept margins below its internal profitability requirements. He argues that the market is at a turning point: “In the German market we don’t yet see margins grow, but we don’t see them decrease any more. There are some cases where pricing is higher, such as in higher-risk deals or transactions which are subject to time constraints. Pbb is above the market average on pricing. New regulatory pressure will probably lead to higher pricing.”
“Borrowers will accept it because the interest level is very low overall,” he adds.
Pricing for unsecured funding for banks outside of the Pfandbriefe has increased recently, says Savills’ Kunde, putting pressure on margins
The drive to maintain profitability in the face of low pricing has led some German banks to increase business outside of their national borders. For some, the emphasis has been on maintaining domestic business and looking for growth in higher-margin geographies.
In its Q1 results, Aareal said that its structured finance division generated increased profits on the back of its push into the US market, in order to neutralise margin pressures. Around 55 percent of its new business last year was in the US. Deka, Helaba and LBBW have also been active across the Atlantic.
“If banks expand in Germany, it is usually for strategic reasons rather than purely for market opportunities,” says Helaba’s Kröger. “We can allow ourselves to pass on deals if we do not feel they are for us. Last year we did more business outside Germany than in Germany, whereas it’s historically the opposite.”
Banks are adopting a cautious and selective approach to lending within Germany. Some are targeting business in sectors such as hotels, logistics and the burgeoning student housing sector in their search for higher returns. There have also been examples of banks providing longer-term finance.
In June, Aareal provided a ten-year €368 million loan to a joint venture between Allianz Real Estate and Belgian logistics developer VGP to finance a portfolio of eight logistics properties located around Germany. In May, Berlin Hyp provided €115 million for 12 years to LEG Immobilien to refinance a portfolio of mainly residential properties in East Westphalia.
However, German banks are not willing to compromise their risk appetite in order to win deals. Prime financing opportunities in the country’s largest seven cities remain the focus for most. “Banks have to look at more and more deals in order to be able to commit to one,” says Savills’ Kunde. “They are not looking for more risk.”
Markus Kreuter, team leader in JLL’s debt advisory division, adds: “There is a continuous fight for core product. Some banks would rather go to top-tier European cities than do business outside Germany’s largest cities, because regional domestic markets are less liquid.”
Development finance is a feature of the market, albeit within a tight risk profile. Core commercial projects are typically financed at margins of below 200 bps. Stephan Kock, a real estate finance partner at law firm Goodwin Procter, says: “Lenders require a high level of pre-let and tend to favour schemes where existing buildings are being expanded or where there is existing income from another element of a scheme in order to mitigate development risk.”
This year’s large development loans include a €150 million facility provided by pbb in June to RFR Group to finance the redevelopment of the vacant Hochhaus am Park office block in Frankfurt into a luxury hotel and high-end apartments. In March, the same bank teamed up with Deutsche Hypo to provide €267 million to Perella Weinberg for the development of two office buildings at the Marieninsel complex in Frankfurt.
Germany’s largest banks posted strong results in 2015, with many exceeding their expectations for the year. This year is likely to be different, with several of the key players warning that volumes and profitability are likely to be below 2015’s levels.
Aareal, for instance, lent €9.6 billion last year, but is targeting €7-8 billion this year. Its Q1 lending, at €900 million, was half that of the same period in 2015. Helaba too has lower expectations for 2016. The bank lent €9.8 billion last year and is targeting a similar amount to Aareal this year. Helaba also warned that profits are unlikely to be as high as they were in 2015.
Although they continue to originate large volumes, there is no doubt that Germany’s bankers are under pressure, and pricing is a major issue for them. Bankers will be looking for further evidence that margins are reaching the bottom.