By Chiara Elisei and Dhara Ranasinghe

LONDON (Reuters) – European banks appear better positioned than U.S. peers to weather any stress from commercial property after an interest rate surge, but that does not mean Europe is out of the danger zone.

Aggressive rate hikes, still working their way through the system, follows a pandemic that hurt foot traffic to bricks-and-mortar retail locations and structurally changed work habits, with office occupancy rates still below pre-COVID levels.

International Monetary Fund estimates suggest banks’ direct exposure to commercial real estate (CRE) was around 6% of bank loans on average in Europe, versus about 18% in the United States last year, meaning Europe appears less vulnerable to risks, analysts say.

(Graphic: Banks commercial property lending Banks commercial property lending – https://www.reuters.com/graphics/EUROPE-REAL%20ESTATE/STRESS/znpnbjrnxpl/chart.png)

Yet, with policymakers alert for what buckles under much higher borrowing costs, potential fault lines are being scrutinised.

Nordic banks and CRE-specialist German banks could be pockets of weakness, especially if systemic risks emerge, Barclays said on Wednesday.

And although CRE risk was not front and centre of last week’s IMF meetings in Washington, concern was visible.

IMF Managing Director Kristalina Georgieva stressed the need “to monitor risks that may be hiding in the shadows, in banks and non-bank financial institutions or in sectors such as CRE.” In its financial stability report, the IMF noted growing concerns about CRE given a heavy dependence on smaller banks.

“Even in Europe then, there may be patches of property-

related vulnerability in the financial system, though none has yet emerged as a major threat to the banks,” said Capital Economics chief property economist Andrew Burrell, noting euro zone commercial property values were expected to fall about 20% before they bottom out.

The European Central Bank’s key rate has jumped to 3% from -0.5% a year ago, and is headed higher.

A recent JP Morgan global investor survey cited CRE as the most likely cause of the next crisis.

(Graphic: Beyond the banking crisis, what do you believe is the likely cause of the next market crisis? – https://www.reuters.com/graphics/EUROPE-REAL%20ESTATE/STRESS/lbvggwazdvq/chart.png)

“If you were to rank what are the biggest risks to your outlook, for us that (CRE exposure) would be among the top three,” said Robeco portfolio manager Daniel Ender.

FAULT LINES

In Europe, where offices account for the bulk of the real estate market, German and Nordic banks most exposed to construction and real estate activities were seen as ones to watch.

(Graphic: European commercial real estate market – https://www.reuters.com/graphics/EUROPE-REAL%20ESTATE/STRESS/zdpxdazwnpx/chart.png)

Barclays said that if CRE became a larger systemic risk, Swedish banks could be more at risk. Borrowing by Swedish property companies has jumped to 2,300 billion Swedish crowns ($223 billion) in 2021 from 1,300 billion crowns in 2012.

German specialised property lenders such as Aareal Bank, Deutsche Pfandbriefbank and Berlin Hyp, have a bigger concentration of real estate exposure, analysts added.

Aareal Bank declined to comment. Deutsche Pfandbriefbank and Berlin Hyp did not return a request for comment.

Robeco’s Ender said although big European banks did not have a “massive amount” of CRE exposure, equity market valuations signalled significant pain for real estate companies, with German names especially trading at substantial discounts to their assets as valued by third-party appraisals.

Tighter bank financing conditions reinforce the effects of higher interest rates, making refinancing tougher over the coming years, analysts said.

The ECB’s banking supervisor last year found “deficiencies” at most banks in how they assess prospective borrowers’ ability to repay. CRE accounts for as much as 30% of non-performing loans across European banks, it said.

Possible redemptions from real estate investment funds, making up 40% of the euro zone CRE market in 2022, having doubled over a decade, according to the ECB, was another worry.

It has warned that “forced liquidation of real estate assets to meet investor redemptions might lead to downward pressure on CRE prices.”

Blackstone recently blocked withdrawals from its $70 billion real estate income trust after facing a flurry of redemption requests. Open-ended real estate funds in Britain have also battled to meet strong demand for redemptions.

“It’s a little bit circular: if banks are finding stresses in other parts of their balance sheets and need to focus on preserving capital to reserve against those losses, this might impact their ability to refinance existing CRE loans, triggering a self-fulfilling prophecy,” said Hans Vrensen, head of research and strategy at real estate investment firm AEW.

In Europe, CRE exposure for smaller banks, more at risk of deposit flight, is estimated at under 30% of all loans, Capital Economics said. Tighter bank regulation also suggests European banks have less to fear.

“[European] banks are in a much better position this time round with larger reserves against potential losses; if you look at the tier one capital ratios, especially in countries like Italy and Spain, it has stepped up tremendously,” said Massimo Bianchi, head of special situations real estate at illimity Bank.

Unlisted global property funds meanwhile have as much as $811 billion in dry powder to support CRE investment when markets recover, Savills estimates. Around $500 billion of this war chest is focused on European assets.

Even if the sector can weather the pain of higher rates, climate risks pose longer-term challenges.

“On one side, there is pressure on lenders to lend more to green projects,” said Jackie Bowie, managing partner at Chatham Financial. “On the other, real estate owners themselves are going to face quite material increase in costs.”

($1 = 10.3323 Swedish crowns)

($1 = 0.9147 euros)

(Reporting by Chiara Elisei and Dhara Ranasinghe; Additional reporting by Yoruk Bahceli in Amsterdam, Sinead Cruise in London and Francesco Canepa in Frankfurt; Editing by Sharon Singleton)

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