Europe bracing for a sharp, abrupt real estate reversal

Bloomberg

Turmoil at trophy properties in London and Frankfurt offer a glimpse of the damage awaiting European real estate investors as they face the sharpest reversal on record.
From a fraught refinancing process for an office building in the City of London to the strained sale of the Commerzbank Tower in Germany’s financial hub, investors are scrambling to find ways to bridge financing gaps as lending markets seize up from rapidly rising interest rates.
The reality check will start to hit in the coming weeks as lenders across Europe get results of year-end appraisals. Hefty declines in valuations threaten to cause breaches of loan covenants, triggering emergency funding measures from forced sales to pumping in fresh cash.
“Europe is going to go through the great unwind of 10 years of easy money,” said Skardon Baker, a partner at private equity firm Apollo Global Management. “The amount of distress and dislocation is off the spectrum.” Loans, bonds and other debt totaling about €1.9 trillion ($2.1 trillion) — nearly the size of the Italian economy — are secured against commercial property or extended to landlords in Europe and the UK, according to the European Banking Authority, a survey by Bayes Business School and data compiled by Bloomberg.
Roughly 20% of that, or about €390 billion, will mature this year, and the looming crunch marks the first real test of regulations designed after the global financial crisis to contain real estate lending risks. Those rules could end up making a correction steeper and more abrupt.
“I think the revaluation will happen more quickly than in the past,” said John O’Driscoll, head of the real assets business of French insurer Axa SA’s investment management unit. “People are starting to get exposed as the tide goes out.”
Europe’s lenders will be prodded by the new regulations to act more aggressively on bad loans. They’re also in better shape than during the last real estate crisis more than a decade ago, so could be less inclined to allow issues to fester. That puts the burden on borrowers.
In the aftermath of the 2008 financial crisis, most banks were reluctant to call in bad loans as doing so would have led to huge losses — a practice dubbed “extend and pretend.” Under new rules on non-performing loans, lenders will have to provision for expected, rather than accrued, losses. That means they have less incentive to sit tight and hope asset values recover.
“The year end valuations done in the first quarter will be key,” said Ravi Stickney, managing partner and chief investment officer for real estate at Cheyne Capital, an alternative-investment fund manager that raised £2.5 billion for real estate lending last year. “The question mark is over what the banks actually do.”
So far valuations haven’t declined enough so that senior debt — the loans generally held by banks — are underwater, but that could soon change. UK commercial properties valued by CBRE Group Inc. fell by 13% last year. The decline accelerated in the second half, with the broker registering a 3% fall in December alone. Analysts at Goldman Sachs Group Inc. have forecast that the total decline could top 20%.
Banks might then act before prices fall further and risk credit losses, forcing indebted landlords into difficult alternatives. The issues get thornier for those facing debt maturities. Lenders are reducing the amount of a property’s value they’re willing to loan out. That means a lower appraisal could act as a double whammy, increasing the funding gap.