Commercial Real Estate: Europe
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Prices
The Green Street Commercial Property Price Index decreased by 1.6% during the fourth quarter of 2022. The index, which measures pricing of a broad swathe of Pan-European commercial properties, is c.16% below its recent peak.
Low starting yields continue to weigh on the industrial and residential sectors, down 4.8% and 6.2% last quarter, respectively. Office asset prices are roughly stable after falling substantially in the first nine months 2022.[1]
| As of January 2023 | Local Currency | Euro Denom. | Change in Comm. Prop. Value (Local Currency) | ||
| Index Value | Index Value | Past Month | Past 3 Mos | Past 12 Mos | |
| Industrial | 168.2 | 163.8 | 0.50% | -4.80% | -16.00% |
| Residential | 132.1 | 131.8 | 0.30% | -6.20% | -14.80% |
| Office | 108.5 | 108.2 | 0.20% | 0.30% | -21.10% |
| Retail | 66.1 | 65.8 | 0.70% | 3.90% | 0.00% |
| Core Sector Average* | 114.4 | 113.1 | 0.40% | -1.60% | -13.00% |
Index History
| Date | Index Level | M/M Change | Y/Y Change[2] |
| 1-Jan-23 | 114.4 | 0.42% | -13.04% |
| 1-Dec-22 | 113.9 | 0.37% | -11.87% |
| 1-Nov-22 | 113.5 | -2.38% | -12.05% |
| 1-Oct-22 | 116.3 | -5.14% | -9.81% |
| 1-Sep-22 | 122.6 | 0.48% | -3.02% |
| 1-Aug-22 | 122.0 | 0.48% | -3.36% |
| 1-Jul-22 | 121.4 | -7.01% | -3.68% |
| 1-Jun-22 | 130.6 | -3.28% | 5.35% |
| 1-May-22 | 135.0 | 0.50% | 9.06% |
| 1-Apr-22 | 134.3 | 1.04% | 8.73% |
| 1-Mar-22 | 133.0 | 0.49% | 7.94% |
| 1-Feb-22 | 132.3 | 0.55% | 9.18% |
| 1-Jan-22 | 131.6 | 1.78% | 8.81% |
| 1-Dec-21 | 129.3 | 0.16% | 6.18% |
| 1-Nov-21 | 129.1 | 0.10% | 7.63% |
| 1-Oct-21 | 128.9 | 2.01% | 8.50% |
| 1-Sep-21 | 126.4 | 0.13% | 6.59% |
| 1-Aug-21 | 126.2 | 0.14% | 7.53% |
| 1-Jul-21 | 126.1 | 1.71% | 7.58% |
| 1-Jun-21 | 123.9 | 0.13% | 6.69% |
| 1-May-21 | 123.8 | 0.19% | 6.67% |
| 1-Apr-21 | 123.5 | 0.31% | 6.58% |
| 1-Mar-21 | 123.2 | 1.65% | -3.74% |
| 1-Feb-21 | 121.2 | 0.21% | -5.24% |
| 1-Jan-21 | 120.9 | -0.68% | -4.85% |
Analyst Outlook
1.Oxford Economist predict additional property value declines in 2023:[3]
- The economic consultancy now expects capital values across commercial real estate sectors in Europe to fall by 10% in 2023 – after an 11% correction in the UK and 3% correction in continental Europe last year.
- Sharper decline for continental Europe than the one experienced during the global financial crisis
2.Citi anayst forecast a 20%-40% decline in asset values over 2023 and 2024.[4]
Office Outlook
Demand[5]
- European office take-up reached 9.9m sq m during 2022, 2% above the pre-pandemic average.
- Looking to 2023, some occupiers are holding off on decision-making, prudently not committing capital at a time of geographical uncertainty,
Leasing
- Leasing activity continued to recover, rising by 14% YoY, as business confidence rose and occupiers resumed activity.
- Southern Europe leasing activity performed strongly against the pre-pandemic average, led by Lisbon (+80%) following a number of pre-lets from professional services companies and Milan (+51%). Conversely, Amsterdam’s take-up fell by 44% against the pre-pandemic average.
- European office lease incentives remained stable between Q1 2022 and Q4 2022, at 10.3% of total lease value
- Average conventional lease lengths remain largely in line, although do vary across the board, with three-/five-year leases more commonplace in mainland Europe and ten-year leases in the UK and Ireland.
Vacancy Rates
Vacancy rates have been increasing since last year:[5]
- Vacancy rates increased by an average of 50 bps from 7.5% to 8% during 2022, most apparent in Dublin (+290 bps to 12.5%), La Défense, (+250 bps to 16.7%), Budapest (+210 bps to 11.3%), and Amsterdam (+220 bps to 7.8%).
- Most of the increase in vacancy rates is reflected in an increase in secondary office stock, or in non-CBD locations following an occupier shift towards best-in-class, CBD-located stock
- Core vacancy rates remain very low however, with Paris CBD (2.3%), Cologne (3.0%), Berlin (3.1%), and Stockholm (3.6%) significantly undersupplied, with some prime rental growth likely to be achieved.
Financing Rates
The all-in interest for a loan on a prime stable asset across European cities now ranges between 4-6%, up from between 2-3% just a year ago.[6]
- Loan interest charged on opportunistic and repositioning assets differ more widely, especially among debt fund lenders. It can range between 5.5-7.5%
- Smaller loans might be priced higher because there is less lender appetite, as well as very large loans (up to €100 million), which might require more than one underwriting lender.
- 92% of banks still only lend into their home market, while only 8% engage in lending across Europe without external subsidiaries or branches.
Loans Performance
The best market estimate assumes a total European CRE debt market of €1.5trillion with an annual new debt origination amount of €310bn. [7]
| Estimation of EU total CRE debt outstanding (€bn) | YE 2022 | Annual origination[7] |
| UK | 280 | 40 |
| Germany | 360 | 90 |
| France | 150 | 30 |
| Spain | 75 | 10 |
| Other | 700 | 140 |
| All Lenders | 1565 |
European Systemic Risks Board Report[8]
Importance of CRE markets for financial stability
- Averse developments in CRE markets lead to a tightening of credit conditions, thereby reducing new investment in the economy.
- CRE investments by investment funds can affect financial stability when the funds are subject to redemption risks, and liquidity needs under stressed market conditions lead to fire sales.
- Banks have not sufficiently performed sensitivity analyses on CRE exposures, especially to measure the potential impact of an increase in interest rates. As a result of these weaknesses, the affordability of some borrowers may not be as robust as banks had originally assumed.
- There could be o significant asset value overstatement due to shortcomings in collateral valuation.
- In a number of EEA countries the investment volume over the past four quarters equalled or comfortably surpassed 1% of GDP as of mid-2022. In other countries, the investment volume exceeded 0.5% of the GDP
- In most countries default rates for CRE loans are higher than those for the stock of loans in other segments of the economy. EU at 15% share of NPLs, with only at about 6% exposure to CRE Loans.
- Investment funds act as buyers in the bulk of CRE transactions, with a share of around 50%. Private investors account for just over 30% of total transaction value, followed by insurers and pension funds, which account for about 10%. Banks only account for a very small share.
- Banks are then exposed to CRE markets (i) via credit risk on CRE loans and changes in values of CRE collateral and (ii) as lenders for investment funds.
- Looking at total exposures (investment in CRE and CRE loans) by investor type, banks have the highest exposure to CRE in most countries. Pg.13
- The assets under management of European real estate alternative investment funds (AIFs) increased by €597 billion in the first quarter of 2017 to €1.06 trillion in the third quarter of 2021. Pg.14
Risk analysis
Collateral stretch
- Income returns have trended downward
- Low-frequency asset valuations increase valuation uncertainty during periods of market stress. Low-frequency valuation cycles can lead funds to report stable prices for their real estate investments, which could undermine trust in real estate funds’ valuations.
Income and activity stretch
- The volume of investment transactions in CRE almost returned to pre-pandemic levels in 2021, but has decreased more recently.
- Perceived risk related to retail property has risen, as shown by yield spreads against ten-year German Bunds.
Financing stretch
- In the banking sector, a significant share of loans have an LTV ratio above 80% in a number of countries, which indicates that the sector is highly exposed to changes in CRE prices. Declining CRE prices could lead to rising LTV ratios, pushing up capital requirements and undermining the ability of banks to provide credit. pg.32
- Even for loans with LTV ratios that might appear more conservative, the aggregate information might hide other, riskier characteristics, such as a bullet repayment scheme, a non-recourse structure, variable unhedged interest rates or long maturities pg.32
- The NPL coverage ratio for CRE loans is much lower than that for total loans to NFCs.
- In 14 euro area countries, variable interest loans make up more than 50% of CRE loans
- Open-ended funds accounting for 31% of the market in terms of NAV showed a misaligned asset-liability maturity structure.
Spillover stretch
- Between the first quarter of 2018 and the third quarter of 2022, an average of 30% of investment in EU CRE came from domestic sources, 57% from European sources other than domestic and 13% from outside Europe
- Euro area banking sector exposures to CRE are mostly domestic, with only a few countries being significantly exposed to CRE markets in other euro area countries
- Currently, more than 60% of CRE loans in the euro area are not securitized
- Insurance companies, together with pension funds, are the largest investors in real estate funds (40% in total), followed by households (15%). Long-term investors can help ensure that investment funds have stable funding structures and thus reduce the risk of large-scale fund redemptions.
- In the event of a CRE market downturn, spillover effects could arise among funds, banks, and financial auxiliaries within the same jurisdiction. However, there are significant cross-border linkages among a few countries.
https://www.trepp.com/trepptalk/european-cmbs-refinancing-risk-in-the-market
https://www.costar.com/article/656826657/blackstone-rattles-market-with-first-european-cmbs-default
https://www.realestate.bnpparibas.com/europe-cre-360-report-february-2023
https://www.spglobal.com/_assets/documents/ratings/research/101571320.pdf
CRE Bank Exposure
Across the European banking industry, CRE accounts for as much as 30% of NPLs. [9]
From the collection of data from 32 of the most CRE-exposed banks, 26% of total corporate exposures are commercial real estate, of which 32% are office and retail. This confirms that CRE is a relevant exposure class for banks.[9]
Banks Risks Found by ECB Banking Supervision
Loan origination
- Several banks have no underwriting criteria and pay insufficient attention to cash flows, also in bad times.
- Several banks lack processes for ensuring that sponsors are directly invested in these projects so that they have adequate “skin in the game”
- Quite a few banks with high share of loans that have a large balance falling due at maturity (known as "bullet" or "balloon" loans) failed to apply a debt yield ratio
Monitoring
- Quite a few banks do not have commonly defined basic CRE risk metrics, such as the loan-to-value ratio. Neither do they have an overview of the loans subject to refinancing risk (particularly relevant for bullet loans and loans with high balloons), nor of the location of the assets financed (prime versus non-prime).
- Banks have in general not sufficiently performed sensitivity analyses on CRE exposures, especially to measure the potential impact of an increase in interest rates. Scenarios developed in the sensitivity analyses are in general too soft.
- Several banks have not considered off-balance sheet items in their analyses, even though these items represent a large part of CRE exposures.
- Banks did not consistently using borrower financial information in each part of the cycle, while some banks did not have automated covenant monitoring tools embedded into processes
Accounting practices
- Criteria for identifying NPLs leave too much room for interpretation, or do not consider the specificities of CRE finance, these risks are often underestimated
- Several banks did not sufficiently capture the forward-looking perspective of borrowers’ financial position when assessing forbearance and unlikely to pay (UTP).
- Many banks had a deficient framework for identifying speculative lending exposures, which are subject to higher risk-weighted capital requirements.
- Inspection teams have identified shortcomings in setting triggers to mark a significant increase in credit risk (SICR), such as the use of a quantile approach
Collateral valuation
- CRE inspectors identified basic shortcomings such as the failure to update appraisal reports according to the Capital Requirements Regulation (CRR) at least every three years.
- Banks also failed to perform an ad-hoc revaluation when market conditions changed.
- Certain banks also exhibited weaknesses in selection of appraisers.
- In several banks, the content of the appraisal reports was not satisfactory. For many asset valuations reviewed, the valuation approach and the calibration of parameter values were not adequate, also leading to significant asset value overstatement.
- Several banks have not set up a quality review framework for valuers. They do not scrutinize key parameters such as the vacancy status of the property, the capitalisation rate of the project , the contractual rents or the maintenance cost of the building, the discount rate or the methodology used.
Emerging risks
- Construction costs
- Normalisation of interest rates
- Bifurcation of the CRE market (prime vs. no prime)
- Climate transition risk
Germany
Office Market
Savills Research
Office markets:
- Vacancies from 2% in 2019 to 4% in 2022, and 5% forcasted in 2023
- Already observing unmistakable indications of falling demand for space, for example in the form of an increasing supply of sublet space and a lower number of rental enquiries. As a consequence, the increase in vacancies of recent years will continue and possibly even accelerate.
- Sudden shift in demand preferences towards higher quality office space. As a result, some of the space that was previously still marketable no longer meets user needs and has fallen vacant
Future headwinds:
- Volume of completed space will be comparatively high, at least in the next two years, and will ensure a greater supply of modern office space
- Economic downturn will, at least temporarily, bring the cost side back into sharper focus for companies - this will also influence their willingness to pay for office space
- Increased demands on office space quality are offset by a lower quantitative demand. According to our impression, at least most large users want to significantly reduce their per capita office space footprint against the backdrop of the hybrid working world that is becoming established
In view of this mix, downward pressure on rents is likely to increase. In 2024, too, the downside risk outweighs the growth opportunities for rents in view of further rising vacancy rates. This could change from 2025 onwards[10]
JLL Research
- Office take-up of 3.5 million sqm in the country’s seven major real estate strongholds, exceeding the same period last year by 6.5%.
- ‘Flight to Quality’ trend. In 2022, Grade A space accounted for around 70% of new lettings.
- For 2023, JLL anticipates a decline in demand of around 10% over the year as a whole due to the imminent economic downturn.
- Vacancy rate across the Big 7 increased by just under 9% year-on-year to 4.7 million sqm, with the vacancy rate rising accordingly from 4.5 to 4.9%
- JLL expects the volume of vacancies to rise more sharply, especially for poorer quality office space. JLL therefore expects the vacancy rate to increase by 60 basis points over the year, to reach 5.5%.
- . In times of crisis, subletting to reduce space and costs is always an option. Currently we have recorded a volume of 735,000 sqm on offer on the market in this form. It makes up just under 16% of total vacancies, which is only a slight increase of 2 percentage points compared to 2021.
- Building prices also improved towards the end of the year. The Federal Statistical Office’s Building Price Index rose by just 2.8% for office buildings at the end of the third quarter, down from 6.8% in the second quarter and 4.7% in the first quarter of 2022
- Around 1.8 million sqm of space is currently in the pipeline for this year, most of which is already under construction. Currently occupied or pre-let space makes up 55% of this, but this share is likely to rise further over the course of the year.[11]
References
- ↑ https://gs-s3-prd-usw2-website.s3.us-west-2.amazonaws.com/uploads/2023/01/10112707/GreenStreet-EREA-CPPIReport-2023January10.pdf
- ↑ https://www.greenstreet.com/insights/CPPI?region=EU
- ↑ https://realassets.ipe.com/news/oxford-economics-downgrades-real-estate-forecasts-amid-banking-turmoil/10065752.article
- ↑ https://www.bloomberg.com/news/articles/2023-03-27/european-real-estate-stocks-face-50-downside-citi-analysts-say
- ↑ 5.0 5.1 https://www.savills.com/research_articles/255800/340337-0#:~:text=Vacancy%20rate%20nudges%20up%20to%208%25,-Rental%20growth%20still&text=Vacancy%20rates%20increased%20by%20an,220%20bps%20to%207.8%25
- ↑ https://www.bayes.city.ac.uk/news-and-events/news/2023/march/new-bayes-european-lending-report-finds-that-borrowers-are-paying-up-to-6-all-in-interest-for-loans-on-prime-european-properties
- ↑ 7.0 7.1 https://www.bayes.city.ac.uk/__data/assets/pdf_file/0005/725585/Eurpean-CRE-Lending-Report-YE2022.pdf
- ↑ https://www.esrb.europa.eu/pub/pdf/reports/esrb.report.vulnerabilitiesEEAcommercialrealestatesector202301~e028a13cd9.en.pdf?94fa2bfacc0cf836fa9f5003bd5a1651
- ↑ 9.0 9.1 https://www.bankingsupervision.europa.eu/press/publications/newsletter/2022/html/ssm.nl220817.en.html
- ↑ https://en.savills.de/research_articles/259694/336541-0
- ↑ https://www.jll.de/en/trends-and-insights/research/office-market-overview