FRANKFURT (Reuters) -The euro zone’s sinking commercial property sector could struggle for years, the European Central Bank said on Tuesday, posing a threat to the banks and investors which financed it.

An ECB report which examines threats to financial stability underscored heightened concern over a property boom that is now unravelling in countries such as Germany and Sweden.

Commercial property prices have been hit by economic weakness and high interest rates over the last year, challenging the sector’s profitability and business model, the ECB said.

The sector is not big enough to create a systemic risk for lenders, but could increase shocks across the financial system and greatly impact the financial firms, from investment funds to insurance firms, collectively known as shadow banks.

“While the relatively limited size of bank commercial real estate portfolios implies that they are unlikely on their own to lead to a systemic crisis, they could play a significant amplifying role in the event of broader market stress,” the ECB said in a Financial Stability Review report.

The ECB issued its report as deep cracks emerged in the property market of the euro zone’s top economy, Germany. The sudden reverse in interest rates has forced some developers into insolvency and put deals and construction on hold.

The construction of one of Germany’s tallest buildings has suddenly halted midway after the developer stopped paying its builder, in yet another ominous sign.

Signa Group, the Austrian property giant and owner of New York’s Chrysler Building, had been making steady progress this year on the planned 64-story Elbtower skyscraper in Hamburg but the company, founded by René Benko, fell behind on payments.

Banks in Austria had 2.2 billion euros ($2.4 billion) in exposure in mid-2023 to Signa Group, a person with knowledge of the matter told Reuters. Raiffeisen Bank International and UniCredit’s Bank Austria accounted for two-thirds of this, said the person, who spoke on condition of anonymity.

In its report, the ECB said that residential mortgages make up about 30% of bank loan books, while commercial real estate (CRE) accounts for about 10%.

“A negative outcome of this type would also drive large losses in other parts of the financial system which are significantly exposed to CRE, such as investment funds and insurers,” it added.

Commercial real estate transactions were down 47% in the first half of 2023, compared with the same period in 2022.

That makes it hard to say how far prices have dropped, but the bloc’s largest listed landlords are trading at a discount of over 30% to net asset value, their largest such discount since 2008, the ECB said.

It said a sample of bank loans to real estate firms implies the recent rise in financing costs may cause the share of loans extended to loss-making firms to double to as much as 26%.

If the tighter financing conditions persist for two years as markets expect, and firms are required to roll over all maturing loans, this number would increase to 30%.

“There are substantial vulnerabilities in this loan book, particularly when considering that it is expected that both higher financing costs and reduced profitability will persist for a number of years,” the ECB said.

“Business models established on the basis of pre-pandemic profitability and low-for-long interest rates may become unviable over the medium term.”

($1 = 0.9168 euros)

(Reporting by Balazs Koranyi; Writing by Balazs Koranyi and John O’Donnell; Editing by Barbara Lewis and Alexander Smith)

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