The financing of commercial real estate in Germany is currently under strain. The increase in non-performing loans (NPLs) in the commercial real estate sector is enormous and is putting both borrowers and financiers at risk. Regulation and supervision by national and European authorities, however, are playing a decisive role in overcoming the NPL problem along with changing economic conditions. In this article, the third in a series, we explore the rise of NPLs in German commercial real estate, the impact of this on the markets, and the response by regulators at the national and EU level.
Background
NPLs are loans whereby the borrower is more than 90 days in arrears with repayments or is unlikely to be able to fulfil their loan obligations in full.
The borrower is therefore at acute risk of insolvency. The financier is at risk of default.
According to an analysis published by the European Banking Authority (EBA) in January 2024, the volume of all NPLs in Germany increased from EUR 31 billion to EUR 34 billion between September 2022 and September 2023. This equates to an overall increase of 9.7 %. In the same period, the volume of non-performing CRE loans rose from EUR 6.2 billion to EUR 9.7 billion, an increase of 56 %.
This development harbours risks for borrowers, and for real estate financiers who have a high volume of CRE loans in their books. In a study published in July 2024, the International Monetary Fund concludes that 18% of the total lending volume of large German banks is attributable to CRE loans. For some of the banks analysed, the proportion is even higher.
Reasons for the increase in NPLs
According to a study published in 2024 by PwC, the increase in NPLs is due to macroeconomic influences and structural changes in the real estate market.
Macroeconomic factors
Rising inflation and interest rates are a key factor. Inflation increases the costs of maintaining and operating real estate and thus reduces profitability. At the same time, higher interest rates lead to higher financing costs, particularly for variable rate loans or financing that is nearing its expiry. The combination of both factors can lead to liquidity problems and loan default risks for commercial real estate portfolio holders.
Rising interest rates have a negative impact on real estate values too. High interest rates also mean higher financing costs for prospective buyers, which reduce the value of the real estate. Real estate outside of prime locations is particularly affected by this. According to the Association of German Pfandbrief Banks, commercial real estate prices dropped by 17.2% between the second quarter of 2022 and the first quarter of 2024.
This reduction in value may jeopardise the loan relationship because key financial figures, such as the LTV ratio, play a significant role in commercial real estate financing. Loan-to-value refers to the ratio of the loan amount to the market value of a real property. Commercial real estate financing agreements typically contain thresholds that must be complied with in this regard. If the value of real estate falls to the extent that the threshold is crossed, this constitutes a breach of covenant. In this case, the borrower has a contractual obligation to remedy this breach (e.g. by retaining excess rent or making unscheduled repayments). If they are unsuccessful due to a reduced profitability of the real estate or a lack of available equity, there is a risk of termination or default on the loan.
Structural changes in the real estate sector
In addition to macroeconomic factors, structural changes in the real estate sector also play a significant role in the negative developments. The trends towards working from home and online shopping have greatly reduced the demand for office and retail properties.
Although we have overcome the COVID-19 pandemic, working from home has now become established as a flexible working model. This trend has led to persistent low vacancy rates in the office real estate sector with the result that many companies have reduced or are planning to reduce their office space.
Online shopping is also causing a high vacancy rate. A study published in 2023 by PwC concludes that shopping centres in Germany have an average vacancy rate of 15% to 20% and that it is generally only possible to re-let rental space by reducing the price per square metre by 16%.
The business model of large retail chains is also under pressure, as the insolvencies of Sinn, KaDeWe and Galeria Karstadt Kaufhof have shown.
High vacancy rates and low prices per square metre increase the risk of insolvency and loan default for borrowers and financiers. Even if income is still sufficient to finance the operation and maintenance of real estate and to continue paying interest and making repayments, there is a risk of breaching contractually agreed financial covenants and causing a reason for termination under the loan agreement. The Debt Service Coverage Ratio (DSCR), which is standard for commercial real estate, is of relevance here. The DSCR is calculated by dividing the net operating income of a property (NOI) by its debt service (interest and repayment). Ideally, the DSCR should be above 100% so that income remains after servicing interest and repayment. If the DSCR falls below the contractually agreed ratio – which is usually significantly higher than 100% – the CRE loan may be terminated.
Possible solutions
There are possible solutions for overcoming the challenges associated with NPLs.
Regulatory framework conditions
Regulation and supervision by national and European authorities are playing a decisive role in overcoming the NPL problem. The European Central Bank (ECB) and the German Federal Financial Supervisory Authority (BaFin) have taken various measures to minimise the risk of NPLs. These include stricter capital requirements and making it mandatory for banks to submit detailed plans to reduce the number of NPLs.
These measures appear to be working. According to a Creditreform study from March 2024, the capital ratios of the banks analysed remain high, even if the buffers that exceed the regulatory minimum are becoming smaller.
Legal consequences and courses of action for borrowers
For borrowers, NPLs can have significant legal consequences, including the risk of compulsory auction and insolvency proceedings.
This risk has materialised in many cases, particularly for project developers. There have been numerous insolvency proceedings over the last two years (e.g. at SIGNA, Development Partner, CENTRUM, Euroboden, Project and GERCHGROUP). The wave of insolvencies in this sector is due to the low use of equity capital, increased construction costs and longer construction periods. In addition, the developers have many projects for constructing office buildings in their portfolio that can no longer be marketed at the calculated prices due to the current challenging market environment.
In most of these insolvency proceedings, the existing structures cannot be maintained due to the large number of construction projects, each at a different stage of development and with different groups of financiers. As a result, the projects and real estate are often sold individually or taken over by new investors or the respective existing financiers. The project developer's business is either wound up as part of the insolvency proceedings or transferred to a new company by means of a sale and continued there under a new name or partly under the old name.
For the complex structures behind project financing of commercial real estate (i.e. senior, mezzanine and equity financing), however, there are also options for restructuring outside of insolvency proceedings.
Firstly, the borrower and the financing parties involved can reach a mutual agreement that assumes a medium-term market recovery and often provides for an extension of the term and an adjustment of the existing financing as well as a later sale of the real estate to repay the loans. These agreements are often backed up by the assessment of independent experts (e.g. through the preparation of a restructuring report) that confirms that the planned restructuring concept is highly likely to succeed. This statement is important in order to exclude the risk of lender liability on the part of the financiers involved if an NPL is extended.
Secondly, if no amicable solution can be reached, it is also possible to restructure NPLs against the will of individual financing parties via the German Act on the Stabilisation and Restructuring Framework for Businesses (StaRUG) proceedings. The core element of the StaRUG is the restructuring plan, which can be used to adjust the term of existing financing agreements. Those affected by the plan will vote on the restructuring plan in groups. If the required majority cannot be reached in individual groups, it is possible to replace the consent of that group.
Legal consequences and courses of action for financiers
Financiers must deal with increased depreciation and the need to establish additional provisions. This can jeopardise their financial stability and lead to more restrictive lending policies.
Banks have developed various strategies to deal with the NPL problem. These include selling NPL portfolios to specialised investors, restructuring loans and making greater use of collateral. The digitalisation and automation of processes can also help to reduce the risk of NPLs. Finally, according to the Creditreform study mentioned above, German banks have become more cautious about expanding their CRE portfolios. As a result, new business has slumped.
Outlook and conclusion
The increase in NPLs in German commercial real estate financing represents a considerable challenge, both economically and legally. Macroeconomic framework conditions and regulatory requirements will continue to have a major impact on the development of NPL volumes. Despite the rising number of non-performing loans, there has not yet been a significant NPL sell-off, as both banks and potential sellers are hoping for a market recovery. It remains to be seen how the market will develop in the coming years.
For more information on NPLs in German commercial real estate, contact your CMS client partner or the autor Dr. Maximilian Hacker.
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