Bad commercial real estate loans at European banks are set to surge in the coming quarters, according to buyers of distressed property debt.

The recent sharp rise in interest rates has made debt repayments unsustainable for many borrowers, creating widespread stress across the sector, several property executives told the DD Talks Non-Performing Loans conference in Barcelona, Spain, on May 16.

"The office market specifically is where we see a lot of stress coming," said Josh Silver, director at Malta-based alternative investment manager APartners Capital.

Secondary concerns

Lower office occupancy following the COVID-19 pandemic is exacerbating the impact of higher interest rates for many office landlords. In particular, the slump in demand for secondary offices — older buildings in peripheral locations — is pushing rents down in many areas, making repaying debt at higher rates even more difficult for landlords.

"The banks don't know what they're going to do with [those loans] at the moment," Silver said. "That's an area where we see a tremendous supply coming."

Concerns about European banks' exposure to commercial real estate have mounted since interest rates began rising across Europe in early 2022. The head of Europe's banking regulator warned in March that lenders need to be prepared for a crisis lasting several years sparked by bad property loans.

Even some owners of better-located, more modern office buildings are facing difficulty due to the extent of the recent rise in interest rates, said Francesco Zanella, managing director of acquisitions at global real estate investment firm Starwood Capital. Investors and lenders are losing money on prime properties in the current environment, Zanella added.

"The problem is the level at which properties were priced originally reflected the risk premium at that time, but today that has completely shifted," Zanella said.

After the gold rush

European commercial property enjoyed several years of record investment before interest rates began to rise across the continent in 2022. A decade of record-low borrowing costs and investors' hunger for returns above risk-free but poorly paying sovereign bonds fueled the boom, pushing yields for some prime office properties below 3%.

The recent sharp rise in interest rates in the eurozone, the UK and many other economies to above 4% has diminished the appeal of commercial property for investors, pushing yields up and weakening valuations.

The spike in interest rates is particularly unsettling the commercial property sectors in Germany, Austria and the Nordic region, said Nikolay Golubev, partner at global multi-asset alternative investment firm Bain Capital.

"There are potentially more opportunities [to buy nonperforming property loans (NPLs)] in these markets because banks offered borrowers very low interest rates, meaning valuations were high, and any change in interest rates brought much bigger valuation drops than in southern Europe," Golubev said.

North-south divide

German, Austrian and Nordic banks have attracted negative attention in recent quarters for their exposure to commercial real estate.

At 20%, German banks' commercial real estate exposure as a proportion of total loans is already in the upper range of European economies, without including the country's savings and cooperative banks, which account for 30% of its banking sector, according to a May 13 report from credit rating agency Scope.

The recent strong economic performance of southern European economies compared to previous cycles has cooled prospects for buyers of bad real estate debt in the region, which was Europe's biggest source of NPLs in the last decade, Golubev said. "It means there are less distressed opportunities in southern Europe or they're more complicated and they're not as obvious as before."

The direction of interest rates will largely determine if European banks will be forced to offload significant volumes of commercial property NPLs in the coming years, Silver said.

"Everyone is hoping, betting that rates will come down, which would bail [property investors] out on two fronts: one, on the cost of debt repayments and the other on the valuation of the assets," Silver said.

The extent to which banks are willing to be patient with distressed commercial property borrowers will also be key, Zanella added.

'Damaged and distressed'

"The end of this cycle will depend a lot on how banks react to it,"Zanella said. "If a lot of commercial property gets repossessed where people are forced to sell then we'll see a very damaged and distressed market pretty fast."

European banks have enjoyed a long run of improving asset quality in recent years after a massive spike in bad debt following the 2008 global financial crash and 2012 eurozone sovereign debt crisis. Nonperforming loans peaked at more than €1 trillion in 2014 before falling to about €300 billion in 2023, largely due to lenders offloading bad debt to investors through sales and securitizations as well as tighter regulation.

European banks' average nonperforming loans as a percentage of total loans remained stable at 2.55% in the first quarter of 2024 compared to the last three months of 2023, according to S&P Global Market Intelligence data. Of the 22 banks with assets of more than €100 billion for which a reported NPL ratio for both periods is available, six recorded an increase in their NPL ratio while six recorded a decrease, the data shows.

European banks' historical and current difficulties with commercial real estate lending should see the role of private credit providers continue to grow in the market, Golubev said.

Getting burnt

"I don't expect to see the banks coming back," Golubev said. "Commercial real estate lending is difficult for them from a regulatory perspective or if they get burnt a couple of times, so I think that's the market that will be growing for us."

Banks also struggle to attract and retain the expertise needed to manage their business with the sector optimally, Silver added.

"The constraint that we've seen is probably not so much a lack of appetite but there's actually a lack of manpower in the banks," Silver said. "Banks may have balance sheet, but they don't necessarily have enough people on the underwriting side."