CRE remains a hot topic when considering the quality and future performance of European covered bond programs. Recently, the covered bond market saw significant bond price swings for a couple of German monoline covered bond issuers exposed to U.S. CRE assets, although prices have since stabilized.

Higher interest rates, expanding e-commerce, and the rise in remote working accelerated by the COVID-19 pandemic have produced unprecedented levels of stress in European CRE. Some sectors now face market value declines that exceed those during the global financial crisis.

In particular, the office sector has seen an average 37% drop in property values between the beginning of 2020 and 2024, according to Green Street data (see chart 1). This same sector experienced only a 16% peak-to-trough market value decline during the global financial crisis. Europe's retail correction has been slow but steady, with property prices gradually deteriorating by roughly 47% since the end of 2015, partly due to ongoing e-commerce competition.

Chart 1

Despite falling prices, CRE performance in covered bonds has remained relatively stable, although S&P Global Ratings has observed a meaningful deterioration recently (see chart 2). Multifamily housing rents--comprising a significant part of the exposure and considered residential in most covered bond markets--have continued to rise on the back of demand due to the lack of housing construction in most markets.

Chart 2

While we believe that overall CRE asset performance will continue to deteriorate in 2024 as valuations bottom out, we see limited impact on our rated covered bond programs. The availability of significant excess credit enhancement remains a key strength for programs we rate, although important differences exist in the market in general (see chart 3).

Generally, CRE exposure is highest for some programs in Germany. For covered bond programs that we rate, available credit enhancement is generally much higher than the overcollateralization commensurate with the rating.

Chart 3

Covered Bonds' Structural Features Mitigate Risks

Alongside healthy levels of overcollateralization, covered bonds have other factors that help cover pools withstand significant CRE losses. The overall exposure to CRE assets in the largest European banks, and in most covered bond programs, remains limited (see chart 4). In many programs, residential mortgages make up most assets, lowering the overall impact of any CRE quality deterioration.

Chart 4

The granularity of banks' cover pools is often a positive factor as CRE behaves differently across geographies and property types. However, certain cover pools have higher exposure to certain property types than others (see chart 5). Indeed, each property type in a cover pool will likely behave differently from a cash flow standpoint depending on its location, tenant makeup, and the condition of the property. Banks also benefit from the liquidity generated by strongly performing CRE assets as they normally also act as bank account providers and liquidity managers.

Chart 5

The dual recourse nature of covered bonds enables investors to benefit from the overall strength of banks' balance sheets. Covered bond issuers typically replace distressed loans in the cover pool with performing loans from their balance sheet. The largest European banks have low average exposure to CRE. Although exposure is higher in cover pools, regulatory limits on loan-to-value (LTV) ratios at origination (typically 60%) limit potential losses for the cover pool. Lastly, office properties--the most stressed asset class within CRE--usually only represent a small portion of rated covered bonds' total cover pool assets.

Challenges Of CRE Exposure

While we generally believe that CRE exposure is manageable on European banks' balance sheets, certain cover pools exhibit higher loan concentration. The ongoing CRE repricing, low levels of new origination, and frequent regulatory requirements to update valuations may cause cover pool compositions and risk profiles to change. In particular, increasing credit problems in CRE may affect the availability of overcollateralization. Furthermore, the size and concentration of CRE exposure, as well as the level of overcollateralization, varies significantly across countries and programs. Covered bond programs in Germany, Denmark, Austria, Spain, and Sweden have the most exposure to CRE assets, including multifamily housing.

Testing The Impact Of Higher CRE Risk

Refinance risk is one of the main risks for European CRE loans in commercial mortgage-backed securities (CMBS) transactions. Unlike CMBS, the refinance profiles in the pools we rate do not indicate a concentration of maturities for CRE loans. Although the risk appears lower for the covered bonds, partly due to the close link to the issuing bank, recent price developments, changes in usage trends, as well as worsening overall performance, have raised concerns for programs exposed to the asset class. Moreover, the European Central Bank's introduction of higher requirements for CRE provisioning reserves for banks has increased issuer and investor scrutiny on CRE exposures.

We have run different scenarios to test rated programs with high CRE exposure, including multifamily housing. We chose programs with an exposure of above 40% of the total cover pool and assumed different stresses, such as a 10% higher expected market value decline (MVD) for the office and retail segments compared to the 75% MVD in our criteria, and higher refinance costs for the office and retail segment. We also tested increases to our recovery time and thereby the cost of recovery.

The outcome of the stressed testing highlighted that rated cover pools remain resilient to lower recovery rates and higher refinance costs. A significantly longer recovery period could lead to higher overcollateralization commensurate with the covered bond rating for some issuers with shorter maturity profiles. The outcome of the testing did not result in us reconsidering our current assumptions and we believe that our current 'AAA' stresses remain appropriate.

Certain programs have comparably low overcollateralization to CRE exposure ratios, and headline risk remains, as well as some pricing risk. Important differences between cover pools cloud the overall risk picture. In our view, the current relatively limited CRE exposure and high unutilized excess overcollateralization of many covered bond programs means that they will be able to absorb potential credit-related losses and continue to be able to refinance the existing cover pool CRE assets. Additionally, they could provide a source of finance for some CRE assets that are currently in CMBS, real estate investment trusts, or on banks' balance sheets, and seeking longer-term funding in the market.

Country Snapshots

Germany

German covered bond programs have the most CRE exposure, mainly comprising multifamily, office, and retail assets, but not all cover pool characteristics are the same (see chart 6). Based on publicly available information, German issuers seem most at risk from server correction in CRE prices. Some notable German issuers have experienced serious stress related to covered bond refinancing, mainly stemming from monoline issuers focusing on CRE assets with exposure to the U.S. market. German CRE prices remain under pressure, giving issuers no respite from foreign market exposure.

Despite the comparably large exposure to CRE, differences in foreign CRE exposure, and overcollateralization levels, the main German issuers have continued to benefit from relatively low LTV ratios, resulting in stable funding rates. According to the Association of German Pfandbrief Banks (vdp), CRE assets--including retail and office--have grown by 3% and multifamily housing by 7.6% from 2023 to 2024 (see chart 7 displaying growth for the top issuers).

Chart 6

Chart 7

Chart 8

Denmark

The Danish CRE market has remained relatively stable, as the return to office has been more pronounced than in other countries. Most covered bond programs have CRE exposure, with multifamily (private rental) housing representing the largest exposure in Danish cover pools (capital centers), followed by office, retail, and agriculture. Chart 8 shows that individual capital centers' exposure to CRE varies--even between centers from the same issuer. The concentration of such assets increases our credit risk assumption for some programs we rate, and the concentration may affect our prepayment assumptions as they tend to be higher in the CRE sector. Due to the tradition of matching mortgage characteristics to covered bonds in most Danish programs, the overcollateralization commensurate with the ratings is relatively low compared to that of other jurisdictions.

Anecdotally, during the recent financial crisis, several CRE properties were refinanced by transferring assets from regional banks to mortgage banks because they could ensure longer and cheaper funding by issuing covered bonds. Although Danish cover pools' exposure to CRE has decreased since last year, nominal overcollateralization remains below the total CRE exposure (see chart 8). We believe that the overcollateralization is commensurate with the current ratings, and that the close relationships between Danish banks and local investors continue to support the Danish covered bond market.

Chart 9

Austria

The Austrian covered bond market comprises two large issuers (Erste and UniCredit), and a large number of regional banks (see chart 9). Although some cover pools contain CRE assets, the regional focus and limited exposure to office and retail have shielded many smaller Austrian issuers. Some issuers have multifamily exposures, while others have exposure to hotels and tourism. Often, the category "other commercial" comprises a significant part of the cover pool. The Signa default has clearly affected the Austrian CRE market, with the number of transactions remaining low. Nevertheless, this has not affected the performance of assets backing the covered bond programs that we rate. The available overcollateralization for our rated programs remains robust and the average exposure relatively low.

Chart 10

Spain

Since the implementation of the covered bond harmonization directive in 2022, CRE exposure for Spanish covered bond programs has decreased significantly and some programs are now residential only (see chart 10). Office and retail comprise an insignificant part of the exposure, with industry dominating the CRE exposures in the cover pools. Exposure to property developers--a source of stress in the global financial crisis--has generally decreased, although it features in some cover pools.

Chart 11

Despite falling available overcollateralization after harmonization, it remains high in an international context, and more than covers CRE loan exposure for now (see chart 11). CRE exposure seems to have stabilized after a period of decreasing exposure. Spanish regulation has no limit on the percentage of CRE assets and the current reductions may eventually reverse, although we believe it is unlikely that CRE exposure will return to previous levels.

Chart 12

Sweden

Swedish covered bond issuers have limited CRE exposure, with most exposure from multifamily housing and tenant association assets, which the market generally considers residential (see chart 12). Swedish multifamily housing refinanced by corporate real estate companies has been a concern for the Swedish real estate market. The reliance on short-term funding has resulted in volatile real estate prices, and real estate transactions dropped significantly between 2022 and 2023. However, recently, housing valuations and ultimately LTV ratios have stabilized. The regulatory CRE limit (10%) in Swedish covered pools continues to shield covered bond issuers, and while the limit does not apply to multifamily housing, issuers may use high unutilized available overcollateralization to fund more of such assets.

Chart 13

CRE Outlook

Chart 14

Related Criteria And Research

• Deutsche Pfandbriefbank Continues To Navigate Difficult Commercial Real Estate Markets, Aug. 14, 2024
• Covered Bonds Outlook Midyear 2024: Growth And Rates Support Performance, July 11, 2024
• Most European REITs' Valuations Should Bottom Out In 2024, July 10, 2024
• U.S. And European Commercial Real Estate Market Stress Reflected In CMBS Downgrades, July 9, 2024
• CRE Debtholders Are Confronting Increasing Refinancing Risk And Charge-Offs In 2024; Outcomes Will Vary, June 3, 2024
• German Residential REITs Remain Supported By Funding Access And Solid Rent Fundamentals, May 31, 2024
• European CMBS Can Ride The Refinance Wave, April 11, 2024
• Swedish Real Estate: The End Of The Slump Could Soon Be In Sight, Feb. 29, 2024
• What Does Property Company Signa's Failure Mean For Ratings?, Dec. 12, 2023
• Danish Covered Bond Market Insights 2023, Nov. 30, 2023
• Swedish Covered Bond Market Insights 2023, Oct. 5, 2023
• German Covered Bond Market Insights 2023, Sept. 13, 2023
• Spanish Covered Bond Market Insights 2023, June 14, 2023
• Covered Bonds Could Ease The Pain In European Commercial Real Estate, May 16, 2023