Signa Holding GmbH (Signa), one of the largest private real estate investment companies in Austria, filed for insolvency in Austria on Nov. 29, 2023, because it faced a substantial liquidity crunch. We believe Signa and several subsidiaries, including Signa Development Selection AG (SDS, 'CC/Negative/--'), will be unlikely to serve all debt obligations. The lack of transparency and the complexity of Signa's structure make it difficult to estimate the total liabilities of the group.

Following the insolvency, we expect established external specialists will push for better transparency and governance throughout the group. Yet, this may take some time and could prolong uncertainties for creditors.

In the following, we address frequently asked questions from investors on the potential impacts of Signa's default on our ratings on real estate investment trusts (REITs), financial institutions, commercial mortgage-backed securities (CMBS), insurers, and covered bonds.

Frequently Asked Questions

What does Signa's default mean for ratings?

• While Signa's default put another dent in the already challenged commercial real estate (CRE) sector, particularly in the valuations of assets that are similar to Signa's, we do not expect that it will trigger widespread stress. Pressure remains on European property developers, most of which are rated in the low sub-investment-grade range, because of declining demand and prices, as well as an increase in construction costs.
• We estimate that rated European banks' gross lending exposures to Signa group entities amount to about €2.7 billion, across 11 rated banks in Austria and Germany. Actual losses will most likely be well below the gross exposure figure, given that the lending has been on a collateralized basis.
• For CMBS, none of the European CMBS loans we monitor feature a borrower related to Signa.
• For insurance, we do not see any material investment concentration on the Signa group that could have a rating impact on any of the insurance groups we rate.
• The current exposures to Signa group do not constitute a risk for our covered bond ratings either. However, a market-wide repricing of CRE assets in the wake of a liquidation at distressed prices could have some implications for the composition of the cover pool programs we rate.

REITs

Do you see any contagion risk for the overall CRE sector in Austria and Germany?

The risk of large-scale asset liquidation at distressed prices could have implications for the CRE market. Should the standing properties owned by Signa hit the market and be sold at prices that are significantly below the market level, the pressures that currently affect the valuations of CRE assets could be exacerbated. Given the lack of transparency, it is unclear how Signa's yields and valuations have adjusted in the past 18 months and how they currently compare with the market. Most CRE properties already went through a large repricing, with yields expanding by an average of more than 100 basis points (bps) and exceeding risk-free rates. We continue to assume that more value corrections will materialize in 2024.

That said, Signa's asset pool may largely consist of prime/modern assets, which typically have low yields, and may not fully represent the overall market. Additionally, it could take time for Signa's assets to hit the market, given the current, potentially lengthy, administration process. We understand that the numerous minority shareholders and secured lenders are evaluating options, some of which could avoid asset sales.

The current freeze of most of Signa's development projects--the value of projects in SDS' pipeline amounts to €8.4 billion, €1.7 billion of which are under construction--could have negative implications for some subcontractors, which were active on several projects across the group.

On a different note, the freeze of Signa's development projects and the recent bankruptcies of numerous developers in the region, such as Germany-based Gerch Group and Development Partner, could benefit CRE landlords because they reduce available supply and vacancy in the market.

Is Signa's case likely to increase refinancing risks for other European CRE companies?

Signa's default could increase lenders' cautious approach toward the CRE sector. Investor sentiment is important for CRE companies to maintain access to funding. We continue to believe that obtaining bank financing on new property developments, especially speculative ones that are not pre-let and riskier by nature, is harder than it was a year ago.

Still, some market indicators, including equity prices of listed European real estate companies (see chart 1), with a few exceptions, have not suffered significantly from the announcement of Signa's default. Instead, they were recovering.

It is worth noting that Signa's situation is specific. We understand the loss of lenders' confidence could also have resulted from the complexity and opacity of the group's corporate structure, the losses from certain subsidiaries, and the track record of aggressive dividend upstreams. We continue to believe governance issues, which have been an increasing concern in the European CRE market, could constrain companies' access to funding and, ultimately, impair their creditworthiness.

Chart 1

What lessons can REITs and developers learn from Signa's case?

Governance standards, in addition to the current market challenges, often have credit implications. Complex organizational structures with numerous minority shareholders typically provide limited transparency and are therefore viewed negatively. Private ownership with opaque holdings also leaves companies vulnerable to the risk of aggressive and unpredictable dividend upstreams. Landlords owning stakes of their corporate tenants also creates the risk of conflicts of interests because it may imply artificially higher rents and valuations.

On the other hand, high pre-sale or pre-letting levels before project launches can reduce developers' reliance on external funding and limit their profitability risk over the construction cycle. In addition, a diversified funding structure with a balanced mix of debt and equity and staggered liabilities should help companies better navigate challenging market conditions.

Financial Institutions

Does Signa's default represent a major source of credit losses for rated banks?

We view the defaults of various Signa group entities as a negative but manageable earnings event for exposed banks. Based on our analysis and discussions with banks and market participants, we estimate that total gross exposures of the 11 banks we rate in Austria and Germany that have exposures to Signa group entities amount to about €2.7 billion in aggregate. For these banks, the exposures account for a sizeable 0.1%-1.5% of customer loans or 0.4%-10.4% of their total adjusted capital (TAC), our measure of loss-absorbing bank capital. Most of these exposures are collateralized loans, financing properties, or development projects in central locations in Austria and Germany.

Because of their collateralized nature, we expect that final credit losses on loans to Signa group entities will, most likely, be considerably lower than the 11 rated banks' gross exposure amounts. What's more, the banks that have these exposures are profitable overall and can absorb additional credit costs.

How much CRE-related downside risk are European banks exposed to?

In aggregate, EU banks' CRE loans represented €1.3 trillion or 11% of customer loans at the end of June 2023. German and Danish banks stand out from other major EU countries, at 20% and 16% of CRE loans relative to total loans, respectively (see chart 2). These figures are for large banks at a consolidated level and include, for example, CRE portfolios held internationally, primarily in the U.S.

Chart 2

The future performance of CRE loan books will largely depend on the quality of the banks' underwriting in recent years. It is hard to gauge this consistently, given the lack of standardized data. We view positively the low default rates and the relatively modest growth rates of these portfolios in recent years (see charts 3 and 4). We also note that bank supervisors in Europe repeatedly called on banks to enhance their risk management capacity and singled out CRE as a source of potential vulnerability, nudging banks to take a conservative approach toward the asset class.

Chart 3

Chart 4

Still, current conditions undoubtedly heighten credit risk in banks' CRE portfolios, given that higher interest rates increase refinancing risks and put pressure on underlying asset values. In particular, banks with a relatively higher exposure to CRE in their lending books or a stronger focus on more vulnerable CRE segments will face greater challenges. Our recent downgrade of Deutsche Pfandbriefbank AG (BBB/Negative/A-2)--a Germany-based midsize CRE lender with U.S. CRE exposures amounting to 15% of its loan book--illustrates how deteriorating CRE markets and increasing losses in CRE portfolios can affect our assessment of banks' credit quality.

In addition, we generally consider that construction and real estate development exposures carry potentially higher risks because of refinancing costs, significant increases in building material expenses, and lower demand in some markets. In aggregate, these exposures represent less than 5% of corporate exposures at default and 23% of TAC for rated banks--but the figure can be higher for some. As such, we have revised the outlook on the rating on Austria-based Hypo Vorarlberg Bank AG (A+/Negative/A-1) to negative, reflecting rising asset quality risks within this construction and real estate development portfolio, which represents 17% of the bank's total credit exposures.

Could CRE exposures turn into a systemic risk for the European banking system?

In theory, yes. History shows that sharp corrections in CRE markets can lead to systemwide banking stress and heightened confidence sensitivity for the most exposed institutions. In the current environment, however, we consider the likelihood of CRE exposures becoming a systemic risk for the European banking system as very low, both under our base case and under a more severe stress scenario.

Under our base case, we expect European banks' cumulative credit losses from all customer loans, not just CRE loans, will average €80 billion a year and represent about 40 bps of customer loans over 2023-2025. This represents an increase from the low of about 30 bps over 2019-2021 but is well below the highs of over 100 bps during the global financial crisis in 2008 and 2009, for example.

Under the three-year adverse scenario in the European Banking Authority's (EBA's) stress test, GDP growth in the EU contracts by a cumulative 6.1%, unemployment rises to 12.5%, and CRE prices contract by a cumulative 32.4%. Under these harsh assumptions, cumulative credit losses from secured corporate exposures--a good proxy for CRE exposures--amount to €25 billion, which accounts for about 2% of banks' aggregated common equity tier 1 (CET1) capital (see chart 5). Even though these credit losses would impair banks' earnings significantly, we consider most banks can manage them because of their broadly robust capital positions. Yet, the risk of second-order effects from CRE market upheavals--resulting, from example, from reduced consumption, higher unemployment, or a decline in investor and consumer confidence--would reduce banks' activity levels and increase losses beyond CRE exposures.

Chart 5

CMBS

How does Signa's default affect the performance of European CMBS?

None of the European CMBS loans we monitor feature a borrower related to Signa. Even if they did, our CMBS methodology assumes a borrower default and repayment of the rated obligations through recovery from a sale of the underlying real estate assets as a fundamental premise. A default of a borrower or loan sponsor would therefore not immediately affect our ratings. We would change our ratings if recovery prospects from the underlying properties changed. Our 'B' rating currently implies a further decline in property market values of approximately 20%-30% from deal to deal. Higher rating categories can withstand much higher value stresses.

Are CMBS loans likely to suffer a similar fate as financings to Signa?

We generally believe that the default rate in European CMBS loans will likely increase over the next 12 months. This is because a large number of loans will come up for refinancing, while lending conditions have worsened significantly since these loans were made five years ago. In addition, CMBS loans benefit from interest rate protection, which expires when the loan ends. These protections were written at much lower rates than the ones that are currently prevailing, meaning borrowers will face higher financing costs. That said, these are common risks that apply to CRE loans--they are not related to Signa's default.

Insurers

How does Signa's default affect the insurance sector?

A few rated insurers in Austria, Germany, and Switzerland have investment exposures to the Signa group in the form of loans, participation certificates, and equities. These exposures are minimal in the overall context of European insurers' investments of about €11 trillion and we do not currently see any material investment concentration on the Signa group that could have a rating impact on any of the insurers we rate. It is worth noting that any volatility or impairments of Signa assets that back participating life insurance policies will follow the profit participation mechanism between policyholders and insurers. Exposures in unit-linked life insurance policies are typically fully borne by policyholders.

More generally, we believe that CRE portfolios are not particularly prominent in European insurers' investment portfolios and that investments in the broader property sector are typically well diversified. On average, the property sector accounts for 3%-4% of European insurers' investments, albeit some insurers allocate a materially higher amount to it.

We will continue to closely monitor illiquid investment exposures, including to real estate. Under our current base case, European insurers' balance sheet buffers have remained robust and can weather Signa's default and the volatility of the broader CRE market without incurring any rating impacts.

Covered Bonds

How does Signa's default affect our covered bond ratings?

We understand that the exposure to Signa-related loans and properties for Austrian and German covered bond programs that we rate is very limited (see table 1) and secured by first-lien mortgages. Therefore, we do not believe that Signa's default has any impact on our covered bond ratings.

However, a market-wide repricing of CRE in the wake of a liquidation at distressed prices could have some implications for the composition of the cover pools in programs that we rate. This is because the eligibility criteria for CRE assets in covered bonds are based on loan-to-value (LTV) ratio limits. If valuations decrease, the loan amount that is eligible for covered bond funding also decreases. If necessary, issuers could include other eligible collateral in the cover pool but this could change the composition and therefore the credit risk of the cover pool.

The credit enhancement that is available to most rated programs is significantly higher than the level required for the current ratings. Therefore, we believe that the available credit enhancement should cushion against any deterioration in collateral performance or changes in the cover pool composition.

We believe covered bonds' longer funding profile can be attractive to refinance CRE. The dual-recourse nature of covered bonds allows issuers to deal with CRE's cyclicality. If market trends change, for example, issuing banks can take a longer view on credit performance and actively engage with borrowers to find solutions. Actively managed cover pools, low LTV ratios, and stable relationships mean banks and borrowers may have more time to find the best solution for distressed assets.

Table 1

Related Research

• Austria-Based Hypo Vorarlberg Bank Outlook Revised To Negative On Rising Asset Quality Risk; Affirmed At ‘A+/A-1’, Dec. 12, 2023
• Signa Development Selection AG Downgraded To 'CC' On Virtual Certainty Of Default; Outlook Negative, Dec. 5, 2023
• Deutsche Pfandbriefbank Ratings Lowered To 'BBB' On Risk Cost Acceleration In Difficult CRE Markets; Outlook Negative, Nov. 17, 2023
• Global Banks: Our Credit Loss Forecasts, Nov. 17, 2023
• Signa Development Selection AG Downgraded To 'CCC' On Financial Challenges; Outlook Negative, Nov. 9, 2023
• EU Banks Resist Tough Assumptions In Latest Stress Tests, Aug. 1, 2023
• European REITs: The Great Repricing Continues, July 18, 2023
• Industry Top Trends Update Europe: Homebuilders and Developers, July 18, 2023
• Industry Top Trends Update Europe: Real Estate (REITs), July 18, 2023
• Signa Development Selection AG Downgraded To 'B-' On Weaker Credit Metrics; Outlook Negative, June 30, 2023
• Covered Bonds Could Ease The Pain In European Commercial Real Estate, May 16, 2023
• Credit FAQ: Spotlight On Refinancing Risks In European Commercial Real Estate, April 24, 2023
• European Banks' Asset Quality: Tougher Times Ahead Require Extra Caution, April 20, 2023
• European CMBS Faces Crunch Time With Loan Maturities Amid Higher Interest Rates, Feb. 23, 2023
• German Residential REITs Face A Mixed Outlook In 2023, Feb. 20, 2023
• When Rates Rise: Softening Demand Threatens European Homebuilders Amid Climbing Costs, Aug. 12, 2022

Editor: Kathrin Schindler.