There has been much commentary about the fate of German banks' lending exposure to the US office market, where prices have been falling precipitously, and losses on lending mounting steeply.
Big name banks like Deutsche Bank, pbb Deutsche Pfandbriefbank, Aareal Bank, LBBW and Helaba have all been making big increases to their bad loan provisions. Aareal Bank said recently about a quarter of its $4 billion loan book for US offices would likely go unpaid, and it anticipated worse to come as the property slump accelerates.
This will certainly have knock-on effects for their lending capacities in their German domestic market over the coming years. With the banks also facing durable regulatory pressures from EU and German regulators, the banks, along with a raft of alternative real estate finance providers, will be facing a "stormy development" in non-performing loans (NPLs), according to management consultants PwC.
Volume of German NPLs rose 56% in Germany last year
In a new report - "Distressed Real Estate: Current challenges and prospects for borrowers and financiers" - PwC says that the volume of non-performing loans (NPLs) in commercial property rose by 56% in Germany last year. Macroeconomic factors in particular make a further increase likely, they predict.
With the office property market yet to bottom out, the higher key interest rate level and the resulting losses in value, a sharp decline in transaction volumes along with new regulatory requirements have now significantly increased the credit default risk, according to the report.
However, a wave of sales of loan portfolios on the scale seen after the major financial crisis is unlikely to materialise, the report says, as institutional investors are increasingly switching to other asset classes.
© PwC
Rita Marie Roland, partner for real estate, PwC Gemany
Rita Marie Roland, partner for real estate at PwC Gemany says: "Falling property values are significantly increasing the risks of existing property financing. Many lenders are still waiting to avoid having to realise losses in value." "Wait and see" will not be a strategy that firms can deploy indefinitely, she adds.
Which loan types are most at risk?
Roland says that loans with variable interest rates and expiring fixed interest rates are particularly at risk of default. Project developers and property developers in particular are currently facing major challenges because income from sales is falling and financing costs are rising at the same time. Subordinated financing tranches - so-called mezzanine financing - are common in the development sector. According to the study, these receivables are at high risk of default. In some cases, even senior tranches are no longer recoverable.
Worst hit are likely to be loans to the office sector, particularly in especially non-energy-efficient offices in B- and C-locations. In many cases, it simply won't be economically feasible to finance and implement urgently needed investment maintenance and upgrades.
"The influence of regulation and supervision is regularly underestimated," says Roland. "In the medium term, these factors will lead to bank-driven loan sales." Those who want to protect their financing from non-performing status should take preventative measures, she warns.
New funds moving into position to capitalise on NPLs
Fund initiators are already lining up vehicles to capitalise on the distressed opportunities provided by the likely wave of non-performing loans in need of workouts or disposal.
© Oliver Platt
Oliver Platt, director, Arcida Advisors
Among them is Frankfurt-based Arcida Advisors which is targeting €300m of equity to buy up non-performing real estate loans in Germany, Austria and Switzerland. In an interview with magazine Real Estate Capital Europe, Arcida director Oliver Platt outlined his strategy to achieve an 18% gross IRR on every loan deal it underwrites.
Arcida is acting as an investment and fundraising advisor to the Luxembourg-based firm Nexum Capital, whose Nexum Debt Potential Fund is targeting NPLs and distressed real estate opportunities. According to Platt, “We are targeting a fundraising size of €300 million in equity and then we will apply leverage. We will target existing senior loan deals between €30 million and €80 million, where the big managers don’t even consider going into a bidding process.”
This is a second attempt by Nexum: the firm had tried launching a €250m fund back in 2022 for German investors. However, the Nexum Turnaround of Real Estate Funds 1 failed to raise sufficient equity from "conservative" German investors, said Platt. Two years later Platt believes the timing is more opportune, while the targeted investor base is more diversified and international. Platt hopes to have a first close in Q3 of this year, and be able to do a first deal with its own discretionary money in Q4.
New BaFin regulations to discourage "extend and pretend"
Arcida says its strategy will be further underpinned by new bank regulatory standards, introduced by German financial watchdog BaFin in June 2023. These new regulations are designed to prevent banks playing "extend and pretend" with loans in their portfolios which don't comply with current ESG standards. Instead, lenders will have to deal with overdue loans, using scientific method to measure assets' sustainability against current ESG benchmarks.
Platt explains: “BaFin emphasises that banks must consider ESG risks in connection with MaRisk (German minimum requirements for risk management). This may mean that fresh capital is no longer available for real estate loans if the collateral is not ESG-compliant after the loan expires. In other words, alternative capital and creative ideas for the stranded assets are required to prevent an NPL in these situations,” Platt said.
The regulations so far only apply to German financial entities, under the watchful eye of the BaFin, but given the similar legal frameworks in Switzerland and Austria, German bank lending to those countries are likely to be impacted in those countries too, believes Platt.
With so many "standstill agreements" now on German bank lenders' books, some going back 18 months or more, the system is clogging up and banks will have to take action to unblock their lending pipelines, particularly where no real progress on resolving the impasse can now be expected.
Additionally, Platt also believes that a further opportunity in the NPL market is provided by the 2019 European Union’s NPL ‘backstop’ measures designed to make banks set aside provisions from their balance sheet to cover future NPLs. These give banks an extra buffer to take swifter action to reduce their NPLs by either selling or writing off these loans.
