Unlike in the US, where the looming ‘wall of debt maturities’ in private real estate is well publicized, the picture of possible distress in Europe is less clear. Price discovery is ongoing, but PERE’s recent conversations with managers and investors suggest that in one particular market, distress could be significant when it does emerge.
In Germany, dealmaking has slowed to a greater degree than any other major market in Europe. H1 2023 volume fell 56 percent against a five-year average, according to MSCI. Only five deals valued at €200 million or more were completed in the first half of the year, per the data provider’s Q2 2023 Capital Trends Europe report.
“What we are seeing with the German market is that there are officially stated prime yields – which have adjusted quite significantly across all sectors, more or less in line with the rest of Europe – but we see very little evidence that transactions are actually taking place at these newly quoted prime yield levels,” says Nicole Pötsch, head of North and Central Europe at PIMCO Prime Real Estate, which manages the real estate mandate of Munich-based insurance giant the Allianz Group, one of the world’s largest investors in the asset class.
Pötsch adds that seller and buyer pricing expectations are not yet meeting, so there is still a gap. As long as this deadlock continues, distress is kept at bay, as it shows there is little pressure to refinance at valuations that reflect the rapid rise of interest rates in the past year.
Market participants PERE spoke with all agree that distress is yet to manifest to a meaningful degree in Germany. This bears out in the data: MSCI pegs distressed sales at only 0.7 percent of total transacted deal volume in Germany so far this year.
“Those investors and other market participants who are seeing distress in their own portfolios or having to undertake financial restructuring are primarily focused on trying to safeguard their equity or debt portions,” says Philippe Grasser, European head of transactions at Paris-based insurance-backed investor AXA IM Alts.
He says this is mainly achieved through loan-term negotiations, extensions, additional capital or preferred equity structures. “What we haven’t seen so far [in Germany] is a lot of products coming to the market at a deep discount. However, we expect this to change if current market conditions persist, especially with regards to large-scale or highly levered situations.”
Upcoming loan maturities are the primary event that will trigger this change. In August, manager AEW estimated that the shortfall between the debt due at loan maturity and the new debt available to repay amounts to €36 billion in Germany for the 2023-26 period. The position of the German banks will dictate how much of this gap can be bridged.
Assem El Alami, head of international real estate finance at mortgage bank Berlin Hyp, does not expect to see a wave of sales caused by loan-to-value or interest coverage ratio covenant breaches.
Speaking on a German lending-focused roundtable for affiliate title Real Estate Capital Europe, he explained that German banks’ underwriting has focused on debt yield in recent years, rather than LTV, although he admits the past year has pushed some loans into stress. “As a Pfandbrief bank, we have a conservative risk strategy, so we have hardly had any risk cases so far. If they do happen, we always look for solutions in partnership,” he added.
However, Marcus Lemli, CEO Germany and head of investment Europe at broker Savills, says there is tension in the market over the position of German banks.
“The official statement is that German banks are very much willing to support their borrowers in order to avoid any kind of distressed situations, and work with their clients to come out of any distressed situations,” he explains. “However, values have dropped significantly, and interest rate costs have doubled or tripled depending on when a loan was secured, and those two reasons point to increasing distress for owners.”
Anecdotally, Lemli adds, the market is trying to stay calm, “but the numbers just don’t add up to a long-term hold for some owners.”
‘A perfect storm’
Shiraz Jiwa, chief executive officer of London-based manager The Valesco Group, expects to see loan covenants come “under serious pressure” in German markets, creating a more pronounced reaction than in other gateway cities such as London and Paris. This is because the yield compression that occurred in the German commercial real estate market between 2013 and 2022 was “unprecedented” relative to historical trading, he explains, whereas deep, established markets like London and Paris “have an in-built downside protection due to historic market cycle comparables and relationships with interest rates.”
Another reason why Jiwa expects significant distressed opportunities in Germany is because many market entrants during this period were from fixed income backgrounds, using income-generating real estate as a proxy for products like bonds, given the decimation of yields in their own markets.
“These assets were deemed particularly attractive because debt was extremely cheap – very low loan margins in Germany coupled with negative euro swap rates – and therefore by nature of these new entrants less emphasis was placed on traditional real estate fundamentals,” he says, adding that these investors also brought a heightened degree of interest rate correlation to the market.
Taken together, these two factors will create “a perfect storm” in Germany when pricing snaps back and yields revert to the mean, observes Jiwa.
Pension fund pain
Given market consensus that values have further to fall in Germany, there will be an outsized impact on institutional investors with direct real estate holdings in the country.
Paul Jackson, managing partner at San Francisco- and London-based Accord Group, a capital advisory firm that opened an office in Munich last year, points out that pension funds in Germany are not only substantially domestically focused, but also have considerable allocations to real estate.
Indeed, PERE data shows that institutional investors based in Germany have the second-highest average current allocation to real estate out of the region’s largest markets, at 16.7 percent. The average for Europe’s seven largest real estate markets stands at 11.3 percent.
“A lot of the German institutions have quite mature investment programs, which means interest rate rises will have affected them significantly,” says Jackson.
“In some other parts of Europe more early-stage pension investment strategies are probably not as badly impacted as those in mature markets, such as Germany, which have been particularly active in the real estate space.”
Such institutions are more likely to be forced to sell for liquidity reasons, adds Jackson. “They’re selling out of quality assets first, unsurprisingly, given those stronger assets are the most liquid.”
Looking forward, Pötsch says she would not be surprised if the level of distress in Germany increases over the next couple of months, citing an increase in the number of developers filing for administration or insolvency in recent weeks. “This will potentially spur more investment activity. But there, of course, the banks play a big role,” she says. “Quite a lot of lenders will now come to the table, so that will impact how these situations will be resolved.”
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