Fears about US commercial real estate have shaken German banks this month, but their message was clear: Don’t worry; most of our real estate exposure is domestic.

Although the country has avoided the rapid market corrections that have shaken the United States, there are reasons to fear the worst. Firstly, German lenders are more exposed to commercial real estate than most European peers.
German banks, alongside their French counterparts, hold the most significant number of commercial real estate loans in the European Union. Still, they have classified a relatively small portion of these loans as nonperforming. The low level of nonperforming loans is partly explained by real estate appraisers in the largest European economy using a long-term approach that smoothes out price fluctuations. German banks also update valuations of the properties they have financed less regularly than their American or British counterparts so that problems may be masked for extended periods.

An index published by the German banking group VDP shows that the value of office spaces dropped by 10% last year, the steepest decline since data collection began in 2003. This index is entirely based on concluded transactions, which have dried up with the recent market downturn. Research firm Green Street, which establishes its index on transactions currently under negotiation, estimates that property values have plunged by 36% since the first quarter of 2022, with some cities like Munich experiencing even steeper declines.

If banks’ internal valuations are excessively optimistic or lag behind market sentiment, charges for loan impairments could increase significantly.

Secondly, German real estate values are particularly vulnerable to rising borrowing costs, as the potential yield on a real estate investment there has been pushed lower than in other markets. However, as yields on government bonds have risen over the past two years, the returns required by real estate investors have also increased. In Berlin, yields have risen to 4.4% from 2.4% in early 2022. This means that an office building generating an annual rent of €10 million would now be valued at just over €227 million if traded today, representing a drop of nearly €200 million over the period.

Thirdly, German lenders’ prudential rules are much more lenient than elsewhere in Europe. A survey by the Bayes Business School published last year showed that German lenders granted senior loans of up to 80% of a building’s value, the highest level in Europe. While the majority of loans were given at lower thresholds, with more significant buildings typically financed at 60% of their value, the contrast is striking with the UK, where banks have been more conservative since being scarred by the global financial crisis.

Commercial real estate is in trouble, and the consequences could extend to the European economy. For now, there are few signs of a crash.
Deutsche Pfandbriefbank AG, a specialized lender stemming from the collapse of Hypo Real Estate, Germany’s most significant casualty of the credit crisis, has seen its bonds sell off sharply in recent weeks due to concerns about its exposure to the United States. The market now awaits the results of the Regional Bank of Hesse-Thuringia, better known as Helaba. Half of its nearly €40 billion commercial real estate financing portfolio at the end of June was tied to office buildings. Many other lenders also hold significant commercial real estate portfolios, including exposure to the United States, such as the Regional Bank of Baden-Wuerttemberg.

Another reason provisions have remained relatively modest so far is that some lenders agree on recovery plans with their borrowers. These may include offering quarterly waivers for existing defaults and short-term loan extensions, provided owners have a clear plan for sales or building improvements.
The German financial sector will remain under pressure, and the European implications of this issue could be profound.