Some of Europe's largest lenders are facing a spike in bad loans linked to commercial property as rising interest rates put landlords under stress.

The recent sharp rise in interest rates across Europe is increasing debt-servicing costs for landlords while demand for space in many commercial properties is expected to weaken as economies slow, potentially depressing rents.

Higher rates are also hitting property valuations as investors balk at more expensive debt financing that makes returns from real estate investments less attractive. A large enough drop in commercial property prices would also breach the debt covenants banks include in loans to landlords, which could prompt lenders to take possession of distressed properties.

"There is a real concern emerging that next year, an awful lot of banks' time could be taken up with managing covenant breaches," Ben Thomason, head of European debt advisory at real estate services firm Colliers, said in an interview. "If interest rates rise to 5% or 6%, there's going to be an awful lot of these transactions that are breaching their covenants."

Alarm bells

Several reports in recent weeks have warned of the deteriorating outlook for commercial property, particularly in the U.K., which is consistently among Europe's most popular investment markets. The IMF said in September that problems in the sector globally could threaten financial stability, while a Goldman Sachs report predicted that U.K. commercial property prices would fall between 15% and 20% from June 2022 to the end of 2024.

Loans to the commercial real estate sector made up around an eighth of total loans by European banks at the end of the first half of 2021, according to a July report by credit rating agency DBRS Morningstar.

European banks' commercial property loan books have grown in recent years after a retreat from the sector in the aftermath of the 2008 global financial crisis, when commercial property prices fell by around 40% from their peak in 2007. Commercial real estate loans as a percentage of retail and corporate loans rose more than 22% to €428 billion from 2015 to 2021 among the 63 European banks with more than €100 billion in assets, S&P Global Market Intelligence data shows.

Among the 10 largest European banks by assets that disclosed data for the period, HSBC Holdings PLC recorded the largest increase in commercial property loans between 2015 and 2021, both in real terms, at about €44 billion, and as a percentage of retail and corporate loans, at 422 basis points to 11.44%, Market Intelligence data shows.

Nordic banks ranked highest among the top five spots for European banks with the largest percentage of commercial real estate loans as a percentage of retail and corporate loans on their balance sheets. Svenska Handelsbanken AB (publ) is by far the largest commercial real estate lender as a portion of retail and corporate loans, with almost 40% of its loan book comprised of lending to commercial landlords, with Skandinaviska Enskilda Banken AB (publ) the second-largest at just under 20%.

Handelsbanken faced a raft of questions from analysts about its commercial real estate exposure during its Oct. 19 third-quarter earnings call. "Our strict credit underwriting policy has been proven for decades and has resulted in very low historical credit losses," CFO Carl Cederschiold said.

Skandinaviska Enskilda Banken referred Market Intelligence to comments made by CEO Johan Torgeby during its second-quarter call that emphasized the bank's "cautious, very conservative view on how much commercial real estate in particular we allow."

HSBC did not respond to a request for comment.

On the turn

Investment in European commercial property hit record levels in recent years. Investors plowed €359 billion into the market in 2021, 8% more than the previous record in 2019, according to U.S.-based real estate services firm CBRE.

Last year's peak was the culmination of a swell of investment in commercial property over the last decade or more. Record low interest rates since the 2008 global financial crisis provided investors with cheap funding and pushed them to hunt for better returns beyond poorly paying bonds. By 2021, investment in European commercial property had risen more than threefold from around €100 billion in 2009.

That boom has come to an end as central banks have rushed to quell surging inflation that has hit its highest level for more than 40 years in many markets. Analysts expect further rate hikes in the coming months from the European Central Bank, Bank of England and the Riksbank of Sweden — where domestic banks have some of the highest levels of exposure to commercial real estate — that will put further pressure on commercial landlords.

With many banks beginning to charge interest rates of 5% and above — more than the current yield generated by a large portion of commercial properties — "debt is no longer accretive," Colliers' Thomason said. "Rising interest rates put stress on the real estate market, there's no question about it," Thomason added.

The shift has led equity investors to off-load European real estate stocks at a much faster pace than other sectors. The FTSE EPRA/NAREIT Europe index, which consists of the most heavily traded real estate stocks in the region, has plunged almost 50% year-to-date, compared to a 20% fall for the all-market STOXX Europe 600.

The performance of listed European property companies should be a warning to the region's banks of what lies ahead, said Johann Scholtz, bank credit analyst at Dutch asset manager Actiam. "I'm a bit surprised that we haven't seen a greater increase in European banks' loan loss provisions given the weakness that we've seen in [real estate investment trusts]," Scholtz said. "REIT's share prices, and especially the [rising] yields on the credit instruments of property companies, are a good leading indicator of the market's expectation of what's happening there."

Loans to retail landlords are likely to pose the biggest problems for banks in the coming quarters as occupiers deal with rising costs and lower consumer spending during a period of inflation, Thomason added. Investment in European retail property had already begun to fall in 2018 due to rising competition from e-commerce before COVID-19 lockdowns spooked investors further.

"A lot of lenders were just starting to get a bit more appetite post-COVID as shoppers returned to retail properties," said Thomason. "[The current environment] is making lenders concerned again about retail."

Some loans on office property could also cause trouble for banks. An increasingly likely recession in much of Europe would weaken corporate demand for office space and businesses' ability to pay rent, impacting landlords' ability to meet rising debt payments, Thomason said. The surge in working from home during the pandemic, which has largely stuck, is also calling into question demand for office space as large corporations reassess their real estate footprint.

Not 2008

Still, a repeat of the damage bad commercial property loans inflicted on European banks in 2008 is unlikely. Lenders are much less exposed and much better capitalized if a similar collapse in the sector were to happen, said Benjie Creelan-Sandford, bank equity analyst at Jefferies.

"If you do some sensitivity analysis around potential losses on commercial real estate lending for banks, it's a very small number relative to what it would have been if you ran the same analysis in 2008 to 2009," Creelan-Sandford said.

Banks' recent experience of handling landlords in severe distress during the pandemic should also prevent any rerun of the turmoil seen in 2008 and its aftermath, Thomason said. Lenders are much better at engaging with borrowers and working with them to solve problems than they were a decade or so ago, the executive added.

"There will be stress on covenants next year," Thomason said. "But I also firmly believe that banks will be there to work through them."