By Mathias Pleissner, Deputy Head, Covered Bonds

Continuing stress in real estate, particularly commercial real estate (CRE), was a key takeaway from the Joint Committee’s (JC) Spring supervisory update on risks and vulnerabilities in the EU financial system, as Stage 2 loans and NPLs are both rising. EU banks reported roughly EUR 1.4trn of loans collateralised by commercial real estate at the third quarter of 2023, EUR 210bn of which was to non-EU counterparties.

German banks’ CRE exposure as a proportion of total loans is already in the upper range of major European economies at 20% but the real number is likely to be even higher as the EBA’s risk assessments do not include the country’s savings and co-operative banks, which account for around 30% of the banking sector.

Most of the banks are also issuers of Pfandbriefe, leading to concerns that German Pfandbrief banks may have put covered bonds, a historically reliable and cheap funding channel, at risk. But on the basis that the share of CRE loans to total mortgage exposure in German Pfandbriefe has actually reduced from close to half in 2014 to 37% today, those concerns are likely unwarranted. While CRE loans have increased slightly in nominal terms, the increase has by no means been at the same speed as total mortgage lending.

Not only has relative CRE exposure shrunk, the mortgage collateral of German Pfandbrief banks has been stable over the last decade. The banks have not shown significant signs of increased appetite for riskier assets or markets.

CRE exposure in German Pfandbriefe

Source: Scope, VDP

Contagion risk from US exposure

Some of Germany’s specialist mortgage lenders and Landesbanken with large commercial real estate portfolios have actively sought to diversify their portfolios across the globe, however, in particular where margins have appeared attractive against the supposed quality and location of the properties.

While the share of domestic commercial mortgages in German banks’ CRE portfolios has been stable at around 60%, and most other country exposures have remained broadly unchanged in the last decade, US exposure had doubled to 8% by the end of 2023 and now ranks third after German and French CRE loans securing Pfandbriefe. While this does not necessarily imply that the risk appetite of German lenders has gone up, it may underpin higher exposure from US contagion risk (as inferred by the JC).

Office exposure a concern

Pfandbrief banks’ risk appetite for property types is focused mainly on office and retail, which together account for a relatively stable 80% of exposures. But retail exposure has shrunk over the past 10 years as a consequence of the segment squeeze on the back of online penetration and the pandemic. That puts the focus today squarely on the office sector, which now accounts for half of the Pfandbrief banks’ CRE exposure.

Office has experienced abrupt and longer-term effects in the aftermath of the pandemic. What we are observing today for office is what shopping centres and retail experienced over the last decade: a correction of values to lower, potentially more sustainable levels.

While the trend shows that German banks have not increased their risk appetite towards CRE in the last decade, it does reveals that the CRE lending secured by office property exhibits a meaningful exposure and that may create challenges for real estate investors and lenders.

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