By Philipp Wass, Managing Director, Corporate Ratings

Deleveraging through asset sales is essential for most issuers to meet creditors’ expectations of de-risked balance sheets.

However, this confronts the sector with a potentially vicious circle given the danger that the selling will only be possible at valuations below latest appraisals, thus leading to a sharp drop in asset values, further weakening balance sheets.

We expect the credit outlook for the sector to diverge increasingly between those companies with robust business models, good market access through having sufficient scale, high asset quality and low leverage to cope with the refinancing challenge and weather a property-market downturn while continuing to invest. For companies without these attributes, the credit outlook is negative.

Figure 1: Refinancing challenge looms for European real estate firms
Maturing capital market debt (European issuers with outstanding capital market debt of more than EUR 10m; EUR bn)

Source: Bloomberg, Scope

Real estate companies turn focus to deleveraging

The European sector faces an aggregate EUR 32bn in bonds maturing in 2024 according to Bloomberg, but the amount rises by more than a third to EUR 44bn the following year, increasing again to EUR 45bn in 2026 before falling back to EUR 32bn and EUR 35bn in 2027 and 2028 respectively. The sector also has considerable long-term debt to refinance in 2034 and beyond.

The scale of refinancing in Europe comes at a challenging time for the sector: high energy costs, rising environmental-related capital expenditure, shifts in demand in some commercial real-estate segments and a crisis in affordable housing. Squaring the refinancing-investment circle may require a severe adjustment in property prices – unless extra state support emerges.

In today’s context of still rising interest rates, most issuers are focused on deleveraging through asset sales to pay down debt maturing this year and next, and sometimes in 2025 and later.

Several companies have also undertaken large bond buybacks at below par including Aroundtown SA, Fastighets AB Balder, Heimstaden Bostad AB and Vonovia SE (A-/Negative), among others.

In addition, some firms are replacing capital-market debt with secured lending with banks. However, the high level of uncertainty means that banks are much more selective in providing commercial loans in a sector where the risk is growing that those loans turn sour. Lending is therefore slow and concentrated among solid clients or those willing to restructure their balance sheets. Nevertheless, some banks are offering more leeway in lending and accepting higher loan-to-value ratios (above 50 %) and lower interest coverage ratios than 18 months ago.

Some real estate companies have also taken advantage of subsidised loans tied to green projects. Take the examples of Vonovia’s EUR 0.6bn, CTP NV’s EUR 0.2bn and GEWOBAG’s EUR 0.3bn financing from the European Investment Bank or Heimstaden Bostad’s EUR 0.7bn sustainability-linked financing provided by a group of banks including the European Bank for Reconstruction and Development.

However, banks will not increase their lending to the real estate sector indefinitely, so the sector will have to seek other forms of financing if only to take advantage of opportunities for acquisitions arising from the financial distress of weaker borrowers in the sector.

Some firms need to grasp nettle of returning to capital markets, seek alternatives

Some issuers are back on the capital market. Spreads are high, despite first signs of easing, so issuing capital-market debt will be much more expensive than 18 months ago.

Given limited possibilities to deleverage or to switch to secured financing, some issuers will be forced to buy into higher priced capital market or mezzanine debt and/or ultimately issue equity (if possible) to confront the maturity wall. As a result, we will see more differentiation in the cost of capital, which will become a guiding factor in distinguishing credit quality in the sector.

High quality assets are also attracting private debt lenders, with alternative lenders on the rise, offering the full spectrum of possible financing layers from senior debt to preferred equity. The main advantage of alternative lenders is the high speed of execution and financing terms, including covenants that are much more closely tied to issuer specifics and allow for higher leverage, while pricing can compete with capital market debt, at least for high-yield issuers.

Other firms will have to accept steep discounts on property sales to enable buy-side financing or undertake larger revaluations to restructure their balance sheets to ensure the availability of financing. This will lead to a greater impact of asset quality on how leverage develops. Generally, we expect to see more distressed asset sales that will lead to a massive repricing especially of older, non-ESG compliant properties.

Some companies have no access to external funding at all

We are seeing an increasing number of defaults, particularly among homebuilders and commercial developers who are facing liquidity constraints as demand has plummeted. These firms have limited means to shift their business models to "develop to hold" from "develop to sell" - both caused by a significant deterioration in affordability and/or declining demand.

The substantial funding needed not only to bridge the time to disposal but also to secure financing of working capital outflows given high construction costs, is difficult to access. Any disposal of unfinished developments in bulk will involve a loss that is likely to trigger a default as well. Most recent defaults include several in Germany: Development Partner AG, Project Immobilien Group, Gerch Development GmbH and Euroboden GmbH.

Sector has significant long-term funding needs to address carbon footprint

Investors should remember the investment challenge the industry faces as the largest energy-consuming sector in Europe, accounting for around 40% of total energy consumption and one-third of carbon dioxide emissions. The Carbon Risk Real Estate Monitor (CRREM), an EU research project, found that emissions from commercial building stock alone would need to fall by around four fifths over 30 years to keep the increase in global temperature below 2°C.

Real estate companies need nimble, multi-pronged financial strategies – partly by cutting their losses on older, expensive-to-upgrade and poorly located buildings in their portfolios – to pull through this period of uncertainty with credit quality unscathed.

In essence, financing the estimated EUR 225bn to EUR 600bn in annual investment** in all of Europe’s property stock needed to meet the EU goal to be climate-neutral by 2050 without compromising its social role in providing affordable accommodation and commercial space may be achievable only through a massive revaluation of real-estate assets – and loss of economic wealth for owners – or through extensive state support.

*Buybacks H1 2023: Aroundtown S.A. EUR 1.2bn at 19% discount; Fastighets AB Balder SEK 5.5bn with discounts of up to 9%; Heimstaden Bostad AB SEK 10.4bn at 8% discount; Vonovia SE EUR 1.25bn at 11% discount

**Calculation: European property stock: ¾ considered inefficient, needed renovation rate: 3% per year equalling 750 million sq m in floor space, estimated costs EUR 330-800 per sq m in deep renovation / Sources: European Commission, Buildings Performance Institute Europe, Scope

To learn more, please join the Scope Ratings webinar "European real estate: is the worst over for the corporate credit outlook?" taking place on Wednesday, October 11th 2023 at 3:00 PM (CEST) by registering here.