Europe's commercial property sector braces for 'big reset'

Last November, the European Central Bank (ECB) issued a stark warning about the state of the commercial property sector within the bloc as part of its wider six-month review on overall financial stability.

It said European property companies are recording huge losses and their debts are at a higher level than before the 2007-2008 financial crisis. These growing problems within the sector have "the potential to amplify an adverse scenario," it warned.

The dire soundings underlined how serious things have gotten within the commercial property sector over the past year.

"If you ever wanted to cause trouble for the financial sector and the banking sector, look at commercial property," Adam Slater, lead economist at Oxford Economics, told DW.

"Time and again it's one of the areas that tends to suffer from too much lending, not enough good quality lending and therefore damage to bank balance sheets when things go wrong."

The question looming over the sector in 2024 is how bad the developing crisis gets.

Rising interest rates do the damage

During the period of historically low interest rates which followed the financial crisis, investors pumped money into commercial property. However, the rise in interest rates over the last two years has hit the sector hard as property values are falling sharply.

Commercial property is strongly tied to interest rates. When the cost of borrowing goes up, the value of commercial properties tends to go down as investors are less willing to buy at higher interest rates.

"I call it a big reset," Sebastiano Ferrante, managing director at PGIM Real Estate, told DW. "That's pretty simply explained and not surprising because we are obviously linked to interest rates."

However, the scale of that reset isn't fully apparent yet as the market has slowed and not many deals are being done.

"The full extent of the damage is not yet seen," says Slater. "It's not being recognized in the price indices and it's not being recognized in bank balance sheets to the extent that it might be down the road."

According to US research group and finance company MSCI, the value of completed commercial property deals has fallen by more than 50% in the United States and Europe over the past 12 months, suggesting owners are trying to stave off the inevitable for as long as possible.

Germany's big problem

For some however, the storm has arrived. Signa Holding, the Austrian real estate company which owns several of Germany's major department stores and which holds a stake in New York's iconic Chrysler Building, filed for insolvency in late 2023.

Signa had built up more than €13 billion ($14 billion) in debt through commercial property deals in recent years, but the rise in interest rates put it under severe pressure as it came under pressure to service multiple loans.

While commercial property's woes extend across Europe and beyond, the problems are particularly pronounced in Germany. Companies such as the Gerch Group, Euroboden and the Project Immobilien Group are in serious financial trouble.  The financial regulator BaFin warned in November that lenders exposed to the sector need to brace for losses.

"What Spain was after the global financial crisis — over-leveraged, over-built — is Germany in a different sense today," says PGIM's Ferrante, who is based in Frankfurt and works extensively within the German market.

He believes Germany's current overall economic malaise, combined with specific factors to do with the commercial property market within the country, means it is particularly exposed to rising interest rates, falling prices and sluggish rental growth.

"Germany had a relatively steep price evolution over the low interest rate period of the last decade," he says. "So we had a slower start than others. But then the curve went up incredibly."

However, strong rental regulation in Germany means rents have not increased even though investors have higher costs to meet because of higher interest rates. "Basically the business case doesn't stand up anymore," he says. He expects the correction to be "quite severe."

Another problem he sees in Germany is that the commercial property sector is particularly dependent on bank financing, and he foresees a major lack of liquidity in the sector over the coming years as banks adjust to stricter lending regulations.

Pandemic shift

While the change in interest rates has dominated the discourse, fundamental shifts connected to key dynamics within the sector came with the pandemic, namely working from home and online shopping.

With more and more people working from home since the pandemic, as well as an acceleration of other trends such as e-commerce and home entertainment, certain commercial property spaces such as offices and retail are less in demand than they were before 2020.

"The pandemic had deeper influences, long term influences, and therefore is more important for long term trends than the interest rate movement, because that's mathematically calculable," says Ferrante.

He says more time is needed to see how deep the trend of working from home will be, but he is intrigued by its potential to change aspects of the commercial property sector in the longer term.

Contagion or contained?

Property crises have the potential to spark wider contagion and expose other vulnerabilities in the financial sector, as the 2007-2008 financial crisis showed.

The recent warnings from the ECB and others underline the seriousness of the situation in commercial property but few believe it will develop into a full-blown financial crisis.

Ferrante says central banks now have a much better overview of bank balance sheets and he believes the crisis will be contained. "I'm relatively relaxed that this is not going to be systematic," he says.

However, he believes the commercial property market itself is in for a long period of adjustment.

"It's going to take time for the market to come back to being recapitalized," he says. "And I think we're going to see a market which has much lower lending capacities than before."

Ultimately, he believes higher interest rates are a normal fact of life for the sector to deal with, and that the core of the crisis stems from the pain of adjusting from the more "abnormal" world of negative interest rates.

"The abnormal phase was the last decade," he says. "This is a pretty normal phase for real estate. This is nothing that real estate hasn't seen before. But correcting from abnormal negative interest rates to now is what I call the big reset."

Edited by: Rob Mudge