The Bank of England warns UK commercial real estate lenders remain exposed to credit losses – both at home and abroad – as borrowers face higher lending costs.
The BoE highlighted lending to the sector as one of the key risks to financial stability, in its quarterly Financial Policy Summary. It explained commercial real estate prices, which had fallen sharply in many advanced economies, “could fall further, leading to significant losses for creditors”.
“A number of smaller banks with significant exposure to commercial real estate, in jurisdictions such as the US, the EU and Japan, have seen large reductions in their equity prices,” the bank reported. “Stresses in exposed banks could affect UK financial stability through a number of channels, including macroeconomic and financial market spillovers, contagion to funding conditions for UK banks, and a reduction in overseas finance for the UK commercial real estate sector leading to further downward pressure on UK valuations.”
The statements were made as the bank outlined an improving economic outlook, with a UK banking system that was “well capitalized” and had ability to support households and businesses even if economic and financial conditions were to be substantially worse than expected.
It also noted major UK banks were less exposed to UK commercial real estate compared with previous cycles. Furthermore, by its own assessments – which included a 45 percent price decline in UK commercial real estate prices from their mid-2022 levels – major UK banks would be resilient to a much larger fall in commercial real estate prices relative to those already observed.
Peter Cosmetatos, chief executive officer of CREFC Europe, told affiliate title Real Estate Capital Europe the report was a “reasonable assessment.”
He said: “The review of commercial real estate-related risks in this report contrasts with recent ECB statements to the Bank of England’s credit, suggesting a more clear-sighted, informed and sober view – perhaps in part as a result of the fact that the commercial real estate financing market really does generally look healthier and more resilient in the UK than in the Euro area.”
Sharp correction risk
However, the BoE flagged risk of a sharp correction in a “broad range of asset prices” and a widening in credit spreads – which could be driven by interest rates remaining higher for longer than expected. “Such a correction could crystallize longstanding vulnerabilities in market-based finance – which remain significant – potentially leading to dysfunction in core markets, amplifying any tightening in credit conditions,” it said.
The report also referenced risks posed to the UK banking system by a property downturn in mainland China. It said the adjustment in the sector would weigh on Chinese growth for some time. Although major UK lenders would “be resilient” to very significant declines in property prices in China and Hong Kong, offshore lenders to the market may be exposed as losses crystallize, it added.
“This could represent another material potential channel of contagion if financial institutions have concentrated exposure to such lenders,” it added.
British lender HSBC is an example of the impact of falling real estate prices in China. In February, its shares suffered their biggest one-day drop in almost four years after it recorded an 80 percent fall in profits linked to a write-down in the value of its stake in Bank of Communications in China. The Chinese lender, which HSBC acquired in 2004, has been impacted by the liquidation of developer Evergrande.
ECB warnings
As Cosmetatos referenced, the Bank of England’s warning follows similar statements by the European Central Bank in recent days. The ECB said on 21 March the commercial real estate sector represented an “emerging risk” to financial stability.
In its annual report on its supervisory activities for 2023, the ECB reported having conducted in-depth assessments of banks’ exposures to the sector, and flagged concerns over banks’ exposures via bullet or balloon loans.
Such loans, which are structured with large balances falling due at maturity, account for 8 percent of the debt due to expire in the next two years, the ECB said.
It added: “A material share of these commercial real estate loans are structured as bullet or balloon loans and as non-recourse loans. These types of financing structures pose higher refinancing risk, meaning…borrowers may need to refinance their loans at much higher costs than originally foreseen.” The report concluded it was now “crucial” for banks to engage with borrowers about such risks.
A report on Monday released by ratings agency Fitch said while interest rate cuts are expected, valuations would “need to fall further” to reflect not only higher lending costs but the necessity to invest capital in transitioning assets to a low-carbon economy.
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