Commercial real estate financing is the Achilles' heel of many banks in the current market environment. According to a report by rating agency Fitch, the total credit exposure of German banks in the commercial real estate (CRE) sector amounted to 567 billion euros in mid-2023. This corresponds to around one tenth of all customer loans, or 113% of the banks' aggregated common equity tier 1 capital.

The main focus is currently on the two specialist financiers Aareal Bank and Deutsche Pfandbriefbank (PBB), which are particularly heavily involved in commercial real estate financing. The share price of Deutsche Pfandbriefbank has been under pressure for months and recently marked an all-time low of 3.75 euros. Some of the bank's subordinated bonds are only trading at around 50% of their nominal value.

At the presentation of its business figures for 2023, new CEO Kay Wolf tried to reassure the markets: PBB's situation, with its "solid“ capital and liquidity position, was significantly better than recent price developments on the capital market would suggest. Nevertheless, the bank is cutting its dividend this year as a precautionary measure – "in order to maintain its financial strength in this late phase of the real estate cycle in the interests of all stakeholders“, according to a statement from the bank. Risk provisions increased almost fivefold in 2023 compared to the previous year, from 44 to 212 million euros. Real estate financing in the USA and project financing in Germany were particularly affected.

Wiesbaden-based Aareal Bank had already increased its risk provisioning at the end of February. These had risen from 192 to 441 million euros last year, more than twice as high. As with Deutsche Pfandbriefbank, Aareal Bank's main concern is US office real estate. The 15 loan exposures in the US office segment resulted in a net addition to non-performing loans of 1.1 billion euros.

It is not surprising that specialist financiers are suffering the most from the commercial real estate crisis, as it is affecting the core of their business models. According to a report by the rating agency Fitch, no other German bank has a higher proportion of commercial real estate loans in its total loan book than the two specialist financiers. At Aareal Bank it is around 90%, at Pfandbriefbank just over 70%.

Large universal banks such as Commerzbank or Deutsche Bank are more broadly diversified, even if Deutsche Bank has the largest US exposure of all German banks in the commercial real estate sector in absolute terms. In relation to their total loan book, however, the federal state banks are significantly more involved in commercial real estate financing. Their shares range between 20 and 35%.

The higher risk provisioning in commercial real estate finance has a negative impact on the banks' profits, even though neither Aareal Bank nor Deutsche Pfandbriefbank have posted pre-tax losses to date. The question is whether the earnings crisis could escalate into an existential crisis. Both banks currently meet all regulatory and supervisory minimum capital requirements.

However, the CRE exposure of the specialist banks also exceeds their common equity tier 1 capital (CET1) many times over. According to Fitch, the factor at Aareal Bank is around 11, while at Pfandbriefbank it is around 10. Only Münchener Hypothekenbank, whose commercial real estate exposure is around eight times higher than its common equity tier 1 capital, has a similarly high value.

However, it is also a fact that not a single German bank has had to raise fresh capital as a result of the real estate crisis. The situation is different in the USA, where the crisis-ridden New York Community Bancorp (NYCB) has just received a capital injection of more than 1 billion dollars from investors to give it some breathing space.

For comparison: According to Fitch, the volume of NYCB's commercial real estate loans recently amounted to 468% of risk-based capital. In relation to the US banks' common equity tier 1 capital, this should correspond to a factor of around 5.3. In relative terms, the German specialist banks have therefore leveraged their CET1 significantly more than the troubled NYBC, whose total assets are, however, also significantly larger than those of Aareal Bank and PBB combined.

„The current situation in commercial real estate is more critical in the USA than in Europe,“ says Frank Grell from the law firm Latham & Watkins. However, more risks and losses have already been realized in the USA than in Germany. It is therefore questionable whether and when the bottom will be reached here. "Uncertainty is always the worst thing in the market,“ says Grell, according to whom it is better to fall down painfully once and get up again. "Even forced sales would have the advantage that there would again be a price factor to build on,“ says the lawyer.

As there is currently hardly any new business, banks have fewer points of reference when evaluating the properties they use as collateral. However, the value of the property has a major influence on the loan-to-value ratios (LTVs) and therefore on the covenants in the loan agreements. According to Fitch, banks must revalue their collateral at least once a year.

According to Fitch, most banks reported LTVs of between 50% and 60% for commercial real estate loan portfolios at the end of the first half of 2023. However, the rating agency assumes that loan-to-value ratios will continue to rise as banks revaluate their collateral. „If banks' internal valuations prove to be unreasonably optimistic or simply lag behind market sentiment, loan impairments could increase significantly,“ writes the rating agency.

According to Fitch, the proportion of non-performing loans (NPLs) in commercial real estate loan portfolios has risen significantly in some cases since the end of 2022. Helaba has the highest NPL ratios at around 4.5%, followed by Aareal Bank (around 4%) and Commerzbank and Hamburg Commercial Bank with around 3% each. According to the report, Helaba recorded the highest increase. Fitch compares the ratios reported at the end of the first half of 2023 with the values at the end of 2022.

Banks have to cover higher risks with more equity, which restricts the granting of new loans and the flexibility of existing financing. "Debt funds are aware of this and are prepared to buy non-performing CRE loans from banks at a discount,“ says Torsten Volkholz from Latham & Watkins. However, banks are still hesitant because they prefer to restructure the affected loans themselves and hold them for as long as is economically justifiable.

One reason why banks have so far been able to withstand the pressure is that the proportion of project financing in their portfolios is relatively low. According to Fitch, these only make up a single-digit percentage of all commercial real estate loans. Loans for completed properties are easier to restructure as, unlike project financing, usually no additional liquidity is required. „Traditional bank financing can be regularly extended as long as no additional money is required,“ says Grell. According to the lawyer, banks are often less willing to provide fresh money during restructuring.