How are German real estate banks making any money?

Given their wafer-thin lending margins, it remains a mystery to many in the real estate industry how the country’s property bankers turn a profit. Lauren Parr asks the question

Germany’s major Pfandbrief banks continue to originate huge volumes of property loans, despite exceptionally tight margins. While intense competition among them has driven loan pricing below 80 basis points in their home market, they routinely undercut local lenders abroad.

The driving factor behind this comes from the banks’ funding method, through the Pfandbrief market – a highly rated type of debenture, which has its roots in the 16th century and is governed by Germany’s Pfandbrief Act. Issuers of Pfandbrief bonds must collateralise their cover pools with assets which then stay on their balance sheets; infrastructure as well as real estate loans are popular.

As a relatively safe investment, Pfandbrief coupons are low. In May, mortgage bank MünchenerHyp issued its first Pfand- brief of the year, raising €500 million on a 10-year covered bond, priced at a 0.625 percent coupon. As is typical, the issue was oversubscribed.

Use of the Pfandbrief model means banks face the continual need to write new business to replenish the pools of assets which underpin their bond issues.

“There is pressure to do a minimum volume to refill cover pool outflow. You don’t just have standard amortisation; you also have repayment, given the core product that is trading, which lowers the cover pool level.To keep a AAA rating in place you have to refill with good product,” says Markus Kreuter, head of debt advisory in Germany at JLL.

High water mark

The challenge banks face is replenishing their cover pools with assets priced considerably lower than loans written earlier in the cycle which are repaying. However, despite the tight pricing, the German property investment market continues to generate financing opportunities for domestic banks. Core German assets are generally considered to be low-risk in comparison to property in some other countries, given the low historical loss rates. It means that they have a strong rating, meaning banks are required to hold relatively low levels of equity capital against them.

“Overall, a low margin could be more pro table than something elsewhere with a higher margin but a worse rating,” says Michael Kröger, head of international real estate finance at Helaba.

Thomas Köntgen, deputy CEO of treasury and real estate finance at pbb Deutsche Pfandbriebank, agrees: “While margin levels in Germany tend to be at the lower end of the spectrum, so are the risk costs.”

In its Q1 2017 update, pbb announced that a high concentration of business in Ger- many during the quarter resulted in a drop in average gross margins across its lending, from around 170 bps to circa 160 bps.

Increased regulation is expected to place additional pressure on pro t margins as, under looming Basel IV regulation, German banks which use internal ratings-based risk models will be forced to allocate risk to loans in a more uniform way, potentially resulting in higher capital requirements.

Despite all this, loan books are growing. The 2016 German Debt Project report by the University of Regensburg showed that real estate loan books were shrinking by 1.5 per- cent in 2011, but by the first half of 2016, the growth rate stood at 5.9 percent. Despite loan repayments, the volume of new business in the market is keeping lenders’ “water level” topped up, the report’s authors said.

This has enabled many institutions to make respectable pro ts from their property lend- ing activity during 2015 and 2016, despite the pressure on margins.

There is a consensus in the market that pricing has finally bottomed out. It is likely to “go sideways” for a time, says JLL’s Kreuter: “If margins were to fall any lower they would be below banks’ costs,” he explains.

While 80-85 bps is regarded as the going rate for senior debt on prime German property, there is plenty of anecdotal evidence that banks will provide debt at as low as 60 bps for clients in certain circumstances. Loan-to-value ratios in lending deals are not edging up across the market, meaning that lenders are not charging higher margins for higher leverage. Pfandbrief legislation limits LTVs within cover pools to 60 percent and lenders have conservative valuation requirements to follow.

Making it pay

The requirement to maintain lending activity despite low pricing is partly mitigated by the banks’ ability to keep production costs under control. The higher a bank’s volume of loan production, the more diluted are its fixed costs.

“You want to do as much core business as possible with the existing structure you’re paying for,” explains JLL’s Kreuter. “If you concentrate volumes your operation becomes more efficient. You have the same size of platform and number of staff, but you can fight low price with high volumes.”

Another way banks are cranking up returns is by providing more complicated financings than the core and core-plus deals offered by the market. “Next to plain vanilla deals we always try to provide clients with some added value by being capable of dealing with relatively complex structures, providing construction loans and multi-jurisdictional financing,” comments Assem El Alami, head of international key accounts and syndication at Berlin Hyp.

Some banks make money by distributing loans through the syndication market: “If we underwrite a €100 million loan, we might place €50 million with insurance companies or debt funds that don’t have execution capacity and make a few extra basis points that way,” explains Thomas Staats, managing director and head of origination within international property finance at Deutsche Hypo. A bank might also skim fees by offering loan servicing.

“There is a role for banks acting as a broker for pension funds and insurance companies seeking longer-term debt,” Staats adds.

Lending against development can generate a premium of 50-100 bps over existing core product, market sources say. “Banks approach it from the standpoint of a completed asset, assessing whether they can take the risk of getting it to completion on top. If it is 40-50 percent pre-let then it doesn’t matter; the rental income will pay interest and debt service even without further let- tings, underpinned by low interest rates,” explains JLL’s Kreuter.

The German Debt Project showed that, between 2011 and 2013, growth in the volume of construction finance remained well below investment property nance. In 2014 and 2015, however, it edged ahead; 22.6 percent growth in project finance versus 18.9 percent for existing properties.

Foreign affairs

There is also a drive to lend outside Germany in a bid to capture higher margins.

The likes of pbb Deutsche Pfandbriebank, Aareal, Helaba, DekaBank and LBBW have targeted business in the US, providing them with deal-flow, without having to climb the risk curve significantly.

“The US is attractive for several reasons – margins are higher, the market is large and there is tremendous liquidity,” says Helaba’s Kröger.

Pbb is another bank which recently began lending in the US market. “Generally speak- ing, the US market allows for margins that will exceed the levels in Germany by 50 bps, rather than 30 bps for a comparable risk, although no two transactions are fully com- parable,” says the bank’s Köntgen.

Nearer to home, margins are also higher in the Netherlands and France, where German banks are targeting core business districts. In Amsterdam, German banks are achieving margins of 50-60 bps above their domestic market, for example. Uncertainty created by the UK’s decision to leave the European Union means there is a higher risk premium attached to lending in that market.

“Since the referendum, we’ve seen mar- gins increasing, yet the average length of office lease is still seven years [compared with five years in Germany] and we do not see that there is much more risk in London than a year before,” said Deutsche Hypo’s Staats, speaking before the UK’s general election result.

In the latest report on UK commercial property lending from Leicester’s De Montfort University, German lenders are cited as the cheapest senior bank debt providers. “British banks say ‘they’re 40bps below us’, German banks say ‘we’re 100 bps above our domestic market’. It’s a question of perspective,” says JLL’s Kreuter.

Staats believes it is the culture of UK and US banks to withstand downward pressure on margins, while the German bankers’ attitude is to continue to write loans even at a cheaper rate or a lower IRR. “Provided it is a high-quality financing, German banks are more prepared to accept a few less basis points in order to do the business for the bene t of turnover,” he says.

However, one loan originator at a German bank, says: “As long as we talk only about revenue not being superb, that’s ok. The minute we see German banks produce losses, issues will arise.”

Risky business

Germany’s real estate lenders might be looking for international opportunities, but they remain determined to maintain market share within Germany to protect their client relationships as well as their standing in their home market.The German Debt Project warned of the danger of lenders relaxing their risk parameters, particularly on covenants.

The challenge in a low-margin environment is to remain disciplined about risk, bankers argue. “Historically, banks have earned good money during the first five years of a typical seven-year cycle, but some of the pro ts have been wiped out in the final two years. The trick now is to minimise the write-offs if and whenever the market turns,” says Berlin Hyp’s El Alami.

Property values are acknowledged as being close to their peak, while investment volumes may be skewed by mega deals such as the €730 million sale of the Commerzbank Tower in September 2016 to Korean investor Samsung SRA Asset Management.

For the time being, German banks are earning decent money on property lending. “That’s the effect of the older portfolio. Higher margins will fade out and revenues will probably be reduced.The twist is not to slip into unreasonable risk,” says Berlin Hyp’s El Alami.

“It is important to make sure that the LTVs of the business that we write are reasonable and there is sufficient equity in a transaction to go through the cycle,” adds pbb’s Köntgen.

Despite the exceptionally competitive environment in which they operate, Ger- many’s banks continue to allocate additional resources to real estate lending, the German Debt Project showed. For the time being, according to JLL’s Kreuter, there is no evidence of a waning appetite for lending: “Germany’s banks are being carried by momentum and show no signs of letting up.”