European banks face a prolonged period of uncertainty over the collateral value of large portions of their commercial property loan books as structural shifts in the real estate sector, higher interest rates and imminent changes to bank regulations test valuation assumptions.

Concerns have grown about the risks posed to banks' balance sheets from falling commercial property prices since interest rates began to rise sharply in Europe and the US in 2022. Significant falls in the value of commercial real estate could force banks to hike provisions for bad property loans or hold more capital, hitting profits and shareholder payouts.

Valuations of office property have become particularly hard to gauge, commercial property valuation experts said. The surge in homeworking since the COVID-19 pandemic, which has depressed demand for certain types of office space, and the introduction of energy-efficient building regulations are significantly impacting investor demand.

"The most difficult sector to value at the moment is office," said Caroline Bathgate, global head of valuations at real estate services business Knight Frank. "The office market has been hit really hard in the last 24 months and there are lots of question marks about where the true value really lies in the office sector."

Office slump

The European office market, of all commercial property types, experienced the largest slump in investment volumes in 2023, falling to below €50 billion, its lowest level since at least 2010, data from global real estate services provider CBRE shows. Investment in office property regularly comprised around 40% of total commercial real estate (CRE) investment in Europe before 2023.

European banks' exposures to the US office market, where the impacts of working from home and building obsolescence are more pronounced, could be an even greater source of uncertainty for property collateral valuations. European lenders have around €56 billion of US CRE loans on their books, according to a report by French investment bank Natixis.

"The problems have accelerated in the US office market," said Jeremy Tham, head of real estate finance valuations at Knight Frank. "Those will be problematic loans."

Troubling data

EU and European Economic Area banks had €1.376 trillion of CRE loans on their books at the end of the second quarter, up about €25 billion year over year, European Banking Authority data shows. The aggregate CRE nonperforming loan ratio rose to 4.4% at June-end from 3.9% a year prior.

Yet the aggregate coverage ratio for European banks' nonperforming CRE loans has fallen over the same period, indicating that banks are not increasing the capital they set aside for bad loans at the same pace as their underlying exposures are rising.

Questionable values

The European Central Bank published a supervisory newsletter in August identifying a range of problems it observed during six years of on-site inspections in how banks commission or carry out valuations. Among the issues were the misapplication of market rates to CRE collateral, the use of inappropriate valuation methods and inputs, and insufficient collection of data on the negative impact of environmental, social and governance factors on valuations.

The inspections found banks or their valuors using transactions from 2021 as a basis for market valuations during the second half of 2022 and throughout 2023 due to a lack of more recent activity. No adjustments were made to reflect the downturn in the commercial property market and the significant change in economic circumstances, particularly the increase in inflation and sharp rise in interest rates, the report said.

Regulators and supervisors have moved to diminish the role of market value in banks' calculations of real estate collateral valuations since the 2007 property crash and its part in fueling the ensuing global financial crisis.

"Market valuations should not be used as the sole basis for lending purposes," said Neil Crosby, emeritus professor of real estate at the University of Reading, who worked with the Bank of England to develop a "long-term equilibrium value" for commercial property. "They should be adjusted when markets are pricing property above or below long-term sustainable values," said Crosby.

Regulations incoming

The introduction of Basel IV regulations in the EU on Jan. 1, which the ECB says will "ensure a prudent and conservative value assessment," will cause further shifts in banks' valuations for property collateral.

Banks in the European Union will be restricted from making upward adjustments to a property's value at the origination of the loan beyond the historical average of its value over the last three years, in accordance with the European Banking Authority's Capital Requirements Regulation (CRR) III, which implements the Basel IV regulations in the EU.

The regulations should result in more conservative and stable loan-to-value ratios — the amount banks lend to borrowers as a percentage of the value of the collateral — said Nicole Lux, senior research fellow and project director, faculty of finance, at Bayes Business School. The change is likely to impact German banks, particularly, those whose CRE exposures have attracted attention amid the current market turbulence.

"The main problem in Germany has been the large expansion of loan-to-value ratios," said Lux. "It's still quite normal that a senior loan goes up to 70% or 75% loan-to-value, which means they are putting themselves more at risk if the valuation is volatile and not quite what they think it is."

'Lessons learned'

European regulators and supervisors' work in recent years to ensure financial stability should mean the current uncertainty around commercial property valuations poses a limited risk to the continent's banking sector, said Keith Breslauer, managing director at Patron Capital, a pan-European real estate investor with a $10 billion portfolio of assets.

"Given the amount of capital on banks' balance sheets and the size of their real estate lending books, the odds of something serious happening that is a problem in the traditional European and UK lending markets is [quite small]," he said.

The prospect of European lenders being forced to take possession of large swathes of commercial property is also unlikely. "Lessons learned" since the post-2007 global financial crisis means they are much more willing to work with problem borrowers for as long as possible before resorting to foreclosures, said Bathgate.

"The feeling we get from speaking to UK and European lenders is that they're lenders, not real estate managers," she said. "None of them want to have these assets on their books, so their first and foremost interest is in trying to keep these loans afloat."