The European real estate industry is not collapsing, despite some doomsayers' claims to the contrary. In its virtual conference on June 18, 2024, S&P Global Ratings and a host of industry speakers cast a light on a sector that is battered but not beaten. A replay of the conference is available here. For a full list of external and internal speakers, please refer to the appendix.

About three-fifths of conference participants see persistently high interest rates as the main risk for European real estate over the next 12-24 months, while about one-fifth consider headwinds in the European office sector are the most pressing concern (see chart 1). Geopolitical risks and contagion risks to banks accounted for the remainder.

Chart 1

Economy Steady, CRE Much Less So

CRE performance remains lackluster but significant spillovers to the broader economy have not materialized yet.  In his keynote speech, John Fell, Deputy Director General for Macroprudential Policy and Financial Stability at the European Central Bank, gave an overview of the current situation in the European CRE market from a financial stability perspective, noting that historical experience shows real estate crises can have severe negative effects on the broader economy. Mr. Fell expects CRE market conditions will deteriorate further, with valuations affected by factors such as higher interest rates and a significant structural drop in the demand for CRE since the COVID-19 pandemic, particularly in the case of lower-quality CRE. Real estate companies therefore face pressures from higher financing costs, falling asset prices, and lower revenues.

European banks' CRE exposures, at less than 10% of loans are not a threat to the European banking system in aggregate.  However, a lack of available data, patchy institutional frameworks, and insufficient macroprudential policies continue to weigh on CRE and pose a challenge to non-banks' expansion plans in the sector.

Economic conditions in Europe will likely improve this year and beyond.  S&P Global Ratings' European Chief Economist Sylvain Broyer noted that the expected soft landing for European economies remains on track, after GDP growth resumed in the first quarter of 2024. What's more, the end of the housing market correction is in sight, with the caveat that a rebound in residential real estate prices will be modest (see chart 2). Labor markets across the eurozone and the U.K. remain robust, while unemployment rates are still close to record lows.

Chart 2

Banks March Ahead, Real Estate Companies Stumble

European banks' appetite for real estate lending is constructive but cautious.  Capital and funding metrics remain robust and supportive for European banks' overall lending appetite. Higher interest rates lead to more opportunities for better margins and provide an incentive for banks to boost net interest income through increased lending. Yet banks' enthusiasm for new CRE loans--that is, lending to new CRE customers rather than renewing existing lending relationships--is more limited. This is particularly the case for office CRE and, to a lesser extent, retail CRE. Banks' more selective approach reflects concerns about declining tenant demand for these property types as well as banking regulators' and supervisors' increased scrutiny for these types of exposures.

Yield expansion in the European real estate sector will likely continue in the first half of 2024 and interest coverage ratios will remain under pressure beyond 2025.  Transactions continue to lag, particularly in the office segment, and risk premiums--the spreads between property yields and the risk-free rate--haven't fully recovered yet. As tenant demand for non-prime office properties remains subdued, the value gap between prime and non-prime properties may widen further. Companies will continue to refinance debt maturities at higher rates, implying further pressure on their interest coverage ratios. The interest coverage ratios of 48% of rated real estate companies won't reach the trough before 2026.

On the plus side, refinancing risks are decreasing and most asset valuations will likely stabilize by the end of the year, in light of decreasing interest rates.  Rental growth over 2024-2025 will benefit from reduced supply and prolonged tailwinds from indexation. Cash flow expectations will increasingly drive valuations as long-term interest rates stabilize. Additionally, investor sentiment improved and led to a reduction in refinancing pressures, as demonstrated by better equity prices and credit spreads, as well as successful hybrid capital exchange offers.

Geopolitical risks could delay the recovery of the European real estate sector.  Geopolitical risks could affect the sector, particularly where they result in an unexpected and material economic deterioration, a significant widening of government yields or real estate investment trusts' spreads, or a sharp downturn in investor appetite for European CRE.

Capital Market And Refinancing Risks Are Slowly Receding For Real Estate Issuers

Positive sentiment prevails.  Almost half of conference attendees expect market conditions for European real estate issuers will improve this year, compared with only 5% who believe conditions will deteriorate (see chart 3). Issuance in the real estate market remains low, with new deals tending to achieve high oversubscription rates.

Fallen angels in the real estate sector were not restricted to specific segments.  The five real estate companies that were downgraded to speculative-grade from investment-grade over the past 24 months weren't confined to certain geographies either. Even though valuations in the office segment are more strained than in other parts of the real estate sector, office companies weren't overrepresented in the 18 downgrades that happened in the past two years. This is because most of the downgrades were driven by refinancing and liquidity issues, as well as high leverage.

Refinancing pressure remains for speculative-grade issuers.  While investment-grade companies have already conducted several successful issuances this year, issuers rated 'BB+' and below turned to the banking market or exchange offers to refinance their debt. Real estate companies' overall liquidity situation has improved and is significantly more resilient than it was 12 months ago.

Chart 3

What's Next For Offices?

An end to valuation uncertainties in the European office segment could be in sight.  Almost one-fifth of audience participants indicated that they expect valuations for European office properties will stabilize by the end of this year, while more than half expect this is more likely by the end of 2025 (see chart 4).

Prime and non-prime office assets are at different stages of the revaluation cycle.  The latter are still in the midst of the repricing process, while the former are close to the end. The overall stabilization of long-term interest rate expectations had positive effects on investors' private asset portfolios and rekindled investor appetite somewhat.

Green certifications are a must-have, among others.  The number of boxes office assets have to tick to generate prime yields continues to increase, with environmental certifications among the main priorities. Office building owners who don't comply with green standards will suffer from decreasing demand, lower rents, and, ultimately, higher capital expenditures as such standards come into effect.

The conversion of unprofitable offices to residential units isn't an easy fix.  Office assets that don't make any money, be it because they're based in secondary locations or cannot meet occupier requirements, won't necessarily become more profitable after they have been transformed to apartments. The initial asset value must be low to justify potentially costly modifications--for example to increase the amount of natural light--that are required to make an office-to-residential conversion economic.

Chart 4

Appendix

Editor: Kathrin Schindler.