Mountain of Debt at Real Estate Companies – A Danger for Banks?

27 Nov 2023 min reading

The real estate market in the Eurozone is grappling with substantial challenges, as some of the major real estate companies find themselves burdened with debt levels not seen since before the financial crisis. In a worst-case scenario, this could precipitate a banking crisis.

Elevating construction costs, soaring interest rates, and escalating losses indicate that the slump in the real estate market might evolve into a full-blown financial crisis. The insolvency of companies like Euroboden, Project Group, and Development Partner in the summer might just mark the beginning of a more extensive wave of bankruptcies that could potentially impact the banking sector. The surge in interest rates is now increasingly affecting even industry heavyweights, with significant players facing the prospect of struggling to service their debts.

In its semi-annual Financial Stability Report, the European Central Bank (ECB) raises the alarm, warning of a crisis. The leverage ratio of the largest real estate firms in the eurozone has now reached levels "close to or above pre-global financial crisis levels," standing at 10 times their profits. With the reversal in interest rates, corporations are finding it progressively challenging to refinance these colossal debt mountains. The most heavily indebted companies could encounter difficulties if they are required to repay their loans.

The ECB reports that the cost of loans for commercial real estate has risen by an average of 2.6 percent since the initiation of the interest rate turnaround. Decreasing sales prices and the shift towards remote work, which is diminishing the demand for office space, are intensifying the challenges. This amalgamation of cyclical and structural difficulties has resulted in substantial downgrades in the ratings of real estate companies.

Experts are apprehensive that business models reliant on low-interest rates could become untenable in the medium term. The looming threat of losses could pose a predicament for the balance sheets of banks, considering that around 10 percent of all bank loans in the eurozone are in the commercial real estate sector. The ECB anticipates that the share of loans to companies in the red will double. If interest rates persist at elevated levels and real estate sales decline, up to 50 percent of all loans could be at risk.

Nevertheless, the ECB emphasizes that a systemic crisis at the eurozone level is "unlikely" due to the looming threat of losses in the commercial real estate sector. Nevertheless, this could be problematic for banks heavily exposed to this segment. The simultaneous crises – inflation, war in Ukraine and the Middle East, interest rate reversal – could heighten the risk of systemically important losses in the banking system.

The residential real estate market is also facing pressure from the ECB's interest rate surge, as 30 percent of all bank loans in the eurozone are tied to mortgages. A substantial weakening of the labor market could pose considerable risks to residential real estate portfolios. Despite these challenges, the residential real estate segment has, so far, remained comparatively stable.

Author: Paulo Lopes