European banks are set for an increasing number of bad loans among borrowers who own ageing and poorly located office buildings.

The impact of environmental, social and governance (ESG) policies on occupiers, investors and lenders is casting doubt on the viability of thousands of office buildings, particularly so-called secondary assets outside prime locations in major cities. Falling demand for office space generally due to the widespread adoption of remote working is compounding the problem.

Landlords are also facing higher debt-servicing costs and falling valuations due to rapidly rising interest rates, driving concerns about banks' exposure to commercial real estate (CRE). Interest expenses for listed European landlords are expected to rise by 12% in 2023, following an 18% increase in 2022, analyst estimates compiled by S&P Global Market Intelligence show.

"Potentially, there is a really huge issue for the secondary office market when it comes to the debt space and loan defaults," Ishdeep Bawa, principal, UK capital markets, consulting and advisory at commercial real estate services firm Avison Young told Market Intelligence. "There's a big affordability crunch coming for borrowers and investors who need to upgrade their secondary office stock."

Banks in the European Union and European Economic Area (EEA) saw commercial real estate loans rise in 2022, according to data from the European Banking Authority (EBA). The banking sector's exposure to secondary and regional offices is widespread from "mainstream lenders all the way through to challenger banks," with family offices and private equity among the most common owners of such assets, Bawa said.

Obsolescence lesson

Much European office stock is at risk of obsolescence based on the European Union's proposed Energy Performance of Buildings Directive, according to a December report by real estate services firm Savills. Most UK office buildings fall short of standards required by 2030, it said. Some 30% of offices in the Netherlands lack appropriate energy performance certificates (EPCs) and would need to get them before leases can be renewed. In France, Italy and Ireland, fewer office buildings have EPCs of A+, A and B than those in the UK and the Netherlands.

"[There is] a huge risk for capital returns due to the proposed regulatory changes in these countries," Savills said.

Read more: US banks well-positioned to handle CRE defaults even as rates rise

The cost of upgrading offices to meet the latest ESG standards could see returns for many landlords "wiped out" in the next five years, further dampening investor demand for such assets and depressing valuations, Nicole Lux, senior research fellow and project director at the faculty of finance at Bayes Business School, City University of London, told Market Intelligence.

Sustainability concerns are also impacting occupier demand for secondary offices and the willingness of banks such as HSBC Holdings PLC, BNP Paribas SA and Deutsche Bank AG to provide financing. Companies are increasingly reluctant to take space in polluting buildings, while the push to decarbonize banks' loan books threatens the availability of debt for investors in such assets.

Work-from-home policies are adding to the problem. Office occupancy rates in Europe's major cities stood at 55% in February, compared to the pre-pandemic average of 70%, according to a March report by Savills.

Occupiers are focused on taking best-in-class space in desirable locations to attract and retain staff, real estate services firm Cushman & Wakefield said in a February report. Offices that offer flexible working, collaboration, staff wellbeing and connectivity are high in demand.

'Perfect storm'

It's "a bit of a perfect storm," said Stephen Green, senior partner for special situations at Patron Capital, a real estate fund with capacity to invest more than $10 billion in assets around Europe. Some offices will no longer be viable and have to be put to an alternative use, he told Market Intelligence.

But repurposing office properties has its own challenges, Avison Young's Bawa said. Redevelopment projects bring higher risk for banks, he said.

"Lenders might not want to participate in the repositioning of assets," added Bawa. "They are very particular about what they are letting their borrowers do with their existing assets."

The bleak outlook for secondary office assets is just one driver of a broader cooling in investor sentiment toward commercial real estate, which saw several record years for investment before major global economies began to raise interest rates in late 2021. European real estate stocks have fallen more than 40% since the beginning of 2022, according to the FTSE EPRA/NAREIT Europe Index.

Listed European landlords' one-year probability of default — a measure of a company's ability to meet its debt obligations — rose significantly in 2022 as central bank interest rates increased, and stood at 2.47% at May 3, compared to 0.36% for the wider S&P Europe 350 index.

The slump in confidence in the sector has been severe enough to threaten some office landlords owning what were until recently considered prime assets. High-rise office buildings in office-dominated areas, particularly those let to a sole tenant, are among the most common assets where debt covenant breaches are emerging, said Ben Thomason, head of debt advisory for Europe, the Middle East and Africa at multinational real estate services firm Colliers.

Problem areas include London's Canary Wharf, Paris and large German cities, he said.

Banks' conservative stance

While uncertainty over the future of such assets remains, banks are expected to maintain a conservative posture.

"Lenders are very much now focusing on reducing leverage to where they were previously," Bawa added. "And they're much more focused on interest cover ratios, debt service ratios, all the way through to completely retrenching from the market entirely."

European banks are well-positioned to absorb losses due to large capital buffers built up since the 2008 global financial crisis. They have also reduced their exposure to commercial real estate much more than many US banks over that period, driven by tighter capital rules, said Bayes Business School's Lux.

Still, EU and EEA banks' CRE exposure ticked up by 9% in 2022, although CRE nonperforming loans fell by more than 20%, according to the EBA. French banks had the largest exposure by total volume, at €275.5 billion as of the end of December. As a percentage of total loans, Sweden's banks had the greatest density, of 13.51%, followed by those in Greece and Norway. Portuguese and Greek banks had the highest NPL ratios in CRE.