The Bank of England’s warning about the risk commercial real estate lending poses to the UK’s financial stability was the latest in a line of negative statements about the sector from central banks in Europe in recent weeks.
The UK central bank used its quarterly financial policy summary, published on March 27, to flag the potential consequences to the wider UK banking system of real estate borrowers, both domestic and in the US and China, of refinancing debt at higher costs. It explained commercial real estate prices, which had fallen sharply in many advanced economies, “could fall further, leading to significant losses for creditors.”
The warning followed a series of similarly anxious edicts from the European Central Bank, the latest of which came on March 21. Commercial real estate, it wrote in its annual report on its 2023 supervisory activities, represented an “emerging risk” to financial stability.
Its concerns were multiple. Chief among them related to European banks’ exposures to the sector via bullet or balloon loans following “in-depth” on-site assessments. These types of financing structures pose higher refinancing risk, it said, because borrowers may need to refinance their loans at much higher costs than originally foreseen.
Ultimately, the ECB is concerned real estate distress poses a systemic risk to the eurozone’s financial system. This concern was prompted in part by the EU’s macroprudential oversight body, the European Systemic Risk Board, which in January 2023 said it was concerned about banks’ exposure to the sector. In some European markets, it said, lending was occurring at “high loan-to-value” ratios.
Real estate industry bodies have expressed their frustration, telling affiliate title Real Estate Capital Europe they are concerned the ECB’s assessment of commercial real estate risks could destabilize a sector that is, from the inside at least, beginning to talk with more positivity about financing conditions. The ECB declined to comment.
Peter Cosmetatos, chief executive officer of property financing industry body CREFC Europe, makes a distinction between the BoE and the ECB’s announcements, however. He describes the BoE’s comments that the UK commercial real estate sector continued to face downward pricing pressure and refinancing challenges as “sober and reasonable,” pointing to the fact the property financing market “really does generally look healthier and more resilient” in the UK than in mainland Europe. Even so, Cosmetatos has criticized the ECB’s lack of engagement with the industry over its concerns.
“I’m troubled by a continuing European regulatory assault on real estate. If the ECB think commercial real estate is dangerous, they ought to appreciate the importance of understanding the industry holistically,” he says. “Instead, we see policymakers operating in virtually impregnable silos, by reference to a global financial crisis notion of the industry.”
He says the BoE is more open to industry bodies such as CREFC Europe, adding its Commercial Property Forum, a cross-industry steering group that gathers quarterly, helps it gain insights from the industry. By contrast, he points to the ECB’s “apparent lack of interest in such informational channels” and a “weak understanding” of the leverage levels in real estate companies.
The result, he says, is a lack of insight into how real estate finance works. “The way the ECB talks about the sector reveals a certain amount of confusion about the different sources of capital and the different routes by which it accesses real estate debt and equity risk.”
He adds: “The post-GFC regulatory assault on commercial real estate debt securitization and commercial real estate lending by banks suggests that EU policymakers should be delighted that some of the commercial real estate market’s credit requirement is now being met by non-banks.”
Jeff Rupp, director of public affairs at INREV, the industry association for investors in non-listed real estate, believes the ECB’s conclusion that real estate poses a risk to the financial system is “completely unfounded.” Rupp says INREV data, which covers 80 percent of European non-listed real estate vehicles, shows the sector is not highly leveraged.
He explains: “I understand the ESRB based its conclusions about the industry on the basis of its research into the listed real estate sector, but they clearly didn’t know that average leverage in non-listed vehicles, weighted by assets under management [at the fund and property level], is around 20 percent. Knowing this information would have shown [them] leverage across the whole real estate investment industry is much lower than assumed.”
The ESRB was not specific regarding its assessment of leverage levels among real estate lenders, only declaring “available data” suggested bank lending was, in certain markets, occurring at “high” LTVs. Rupp adds if the ESRB had included its assessment of non-listed vehicles – which is much larger than the listed sector – in its January 2023 paper, it would have “significantly lowered” the calculations on average leverage in real estate funds.
NBFIs probe
After many years of focus on banks, regulators are now turning their attention to whether the private market requires stricter oversight. Internationally there is an effort to expand financial stability regulation into investment markets.
Central banks and financial regulators, such as the UK’s Financial Conduct Authority, have been individually probing the risks to the financial system of the overall private lending market, referred to as ‘non-bank financial institutions.’
ECB vice-president Luis de Guindos made reference to commercial real estate’s role in the NBFI sector at a press conference following the central bank’s latest interest rates announcement on March 7. He said it was looking “very carefully” at non-banks with exposure to the sector, saying it was more concerned about non-banks’ exposure to real estate than it was about the exposure of banks.
The NBFI sector is a broad term covering the private market. In the context of real estate, NBFIs include an array of entity types – real estate investment funds, insurance companies and pension funds that invest directly in property and indirectly through real estate equities and debt. Central banks fear, for instance, the connection between such entities and the banks, one example being the provision of loan-on-loan finance from an investment bank to a private real estate debt fund.
The BoE’s director of financial stability, strategy and risk, Lee Foulger, hinted at the potential for regulation for NFBIs on January 29 in a speech, in which he said: “It is… important, as it is for all parts of the financial sector and real economy, to understand how the transition to a higher rate environment will affect the private credit markets and in particular whether and how the business model risks in the sector will interact [with] macro vulnerabilities.”
As a result, both CREFC Europe and INREV are calling on the ECB to open a dialogue with the industry, arguing that its public statements are based upon limited and often historical knowledge about the sector.
Cosmetatos agrees greater visibility should be regulators’ priority when it comes to real estate finance, given some lending activity has been moving into the private market. But he says: “The ECB need better data, and better qualitative insight such as a more constructive dialogue with the industry. For now, it is premature to conclude the sector poses a risk to financial stability.”
Nicholas Smith, managing director, private credit, at the Alternative Credit Council, a trade association representing private credit managers, believes regulators, having realized they have blind spots about a private market, are eager to rectify them. However, Smith adds: “The challenge for the industry is that policymakers are grouping together a set of relatively disparate elements and concluding ‘something must be done.’”
He explains: “The corporate lending markets are very different from asset-backed lending or lending to the real estate sector, for instance. Putting these markets together and saying there’s a collective case for looking at NBFIs doesn’t strike me as persuasive. If people think there are potential risks, then let’s get some data.”
Smith says the ACC’s own research into leverage in the private market, which includes data from real estate lenders, shows that leverage levels are broadly stable. “We have data that tracks this going back almost a decade, and the percentages of funds operating on an unlevered basis have broadly stayed the same. Unlevered funds and those funds operating with lower levels of leverage account for around 85 percent of the [European] market. This suggests that leverage is not ramping up significantly.”
There are signs the ECB is committed to its pursuit for more information. On May 22, the European Commission is due to host a public workshop as it launches a targeted consultation about NFBIs to seek to collect information on credit institutions, their interconnectedness with the banking sector and how this may be creating a build-up of risks in the system.
Rupp, who will be attending, says: “I have sympathy with why they need to do this, it is very sensible to try to figure out the landscape and how it functions. Fact-based policymaking is crucial.” But he adds: “However, it is irresponsible of the ECB to continue to make the kind of statements they are making about real estate ahead of that process.”
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