## 1. Real Estate Price Developments ## Source details **Canonical URL:** [1. Real Estate Price Developments](https://www.imf.org/-/media/files/publications/selected-issues-papers/2024/english/sipea2024035.pdf) ## Other formats - [Markdown version](/-/media/files/publications/selected-issues-papers/2024/english/sipea2024035.pdf.md) - [Structured JSON version](/-/media/files/publications/selected-issues-papers/2024/english/sipea2024035.pdf.json) --- ### Introduction - Structural change in demand and higher interest rates have contributed to weakness in pricing of commercial real estate (CRE) globally, especially for offices and urban retail. - Monetary policy tightening after the pandemic increased refinancing costs and lowered collateral valuations, contributing to borrower difficulties servicing principal and interest on CRE loans. - NPLs related to CRE for German banks rose substantially during 2023, raising credit and market risk concerns for banks and insurers. - Key authority actions recommended: continue close supervision of institutions with CRE exposures; ensure adequate provisions; maintain macroprudential buffers; review and test financial safety arrangements; explore measures to bolster banking system earnings over the longer term. ### Real Estate Developments - CRE indexes from peak in early 2022: - US: down about 21 percent - Germany: down about 17 percent - Euro area: down about 12 percent - German house price index: - Declined some 10 percent from its peak - Had appreciated more than 60 percent over the past decade - Index and cross-country comparison caveats: - Index composition differs (mix of offices, retail, warehouses, multi-family etc.) - Index construction varies (transaction-based vs. rental-yield–based) - CRE loan characteristics differ across markets (loan duration, amortization pace, refinancing exposure) ### CRE Loan Performance and Delinquencies - NPL developments: - NPL ratio on German banks’ CRE loans: rose to 3.8 percent by end-2023 from about 2 percent at the start of the year - NPL ratio on German banks’ CRE loans in the US: rose to 10 percent by end-2023 - Loan-to-value (LTV) averages reported by banks: - US CRE loans: about 80 percent - German CRE loans: 65 percent - Observation: delinquencies have risen but defaults have not increased correspondingly due to banks extending maturities or adjusting loan terms; significant variation exists across individual banks. ### Exposures of Financial Institutions to CRE - Sample of top 15 German banks (excludes German subsidiaries of foreign banks): - For these 15 banks, CRE exposure averages 18 percent of their loan books. - Nearly 2/3 of this CRE exposure is in Germany. - Exposure to US CRE averages nearly 11 percent of their CRE loan books; this US exposure is concentrated in a few large banks. - Composition by lender type: - Large universal banks: higher exposure to multi-family housing loans vs. offices. - Regional Landesbanks, mid-range banks, and specialized lenders: more exposure to office properties. - Performance varies by location (e.g., largest cities vs. rest of country). - Insurers: - CRE exposure averages 8 percent of asset portfolios. - Insurers typically hold physical CRE assets long-term and may still realize long-term capital gains notwithstanding recent price declines. - Stress example: applying a 25 percent decline in CRE prices to insurers’ holdings implies a 2 percent decline in asset valuations, other factors constant. - High solvency ratio of insurers cited as 330 percent (life and non-life combined). - Insurers may also hold equity or corporate bonds issued by CRE-related firms; valuation deterioration for these is less certain given available information. ### Solvency Stress Analysis and Results - Illustrative adverse 1-year scenario assumptions: - CRE NPL ratios: 10 percent on German/EU CRE; 15 percent on US CRE - 100 percent conversion of NPLs to default (in some scenario variants 50 percent conversion is also considered) - Legal/operational costs: 30 percent of the foreclosure price - LTV buffers assumed: 80 percent on German CRE loans; 85 percent on US CRE loans (alternative LTV assumptions explored in scenario variants) - RRE LTV: 85 percent - RRE NPL ratios in scenarios: 0.8 percent or 1.5 percent (scenario variants) - Earnings shock: 30 percent reduction versus 2023 (to adjust for record 2023 profits) - Results net of provisions; earnings either fully reinvested or excluded in variants; no further realized market losses on securities assumed - Stress exercise findings: - Under the main adverse scenario (NPLs to 10 percent German/EU and 15 percent US, 30 percent reduction in 2023 earnings), three banks out of the 15 in the sample face a capital hit but remain reasonably capitalized. - Scenario sensitivity: different assumptions on NPL conversion rates, RRE NPL ratios, LTV buffers, and earnings treatment affect the distribution and magnitude of CET1 ratio impacts across banks. - Context on earnings assumption: - The 30 percent reduction vs. 2023 earnings partly adjusts for record 2023 profits generated by banks due to policy rate tightening where lending rates rose faster than deposit rates; deposit rate repricing during 2024 could further reduce bank net interest income once fully realized. ### Covered Bonds and Market Risk - Covered bond protections and practices: - Holders of covered bonds are not exposed to credit risk of underlying CRE loans while issuer remains solvent; if issuer defaults, covered bondholders have full recourse to underlying collateral and protection from bail-in. - Legal requirement: at least 2 percent more in nominal amount of loans collateral versus par value of covered bonds issued. - Eligibility: CRE loans eligible as collateral up to 60 percent of a property’s lending value (“Beleihungswert”). - Typical additional bank collateral cushion: often as much as 20–30 percentage points beyond the two percent requirement. - Diversification: banks frequently diversify covered-bond collateral across residential and commercial real estate and must add high-quality liquid assets for liquidity protection. - Market developments: - Spreads on covered bonds widened for some banks during February–March 2024 but largely recovered through early June 2024; corresponding market losses on banks holding such securities have reversed. ### Results of alternative assumptions in the stress scenario - Relaxing conversion assumption: - If the assumption on all NPLs going into default is relaxed to allow only half of NPLs to go into default, then the capital impact on banks is less severe, with only one bank facing a capital hit, which is marginal. - Other assumptions that materially affect outcomes: - LTV cushion on German and US CRE. - The peak NPL impact on German banks’ exposure to CRE. - Potentially higher RRE loan losses. ### Caveats and omitted risks in the analysis - Losses on other types of loans: - The scenario does not assume deterioration in the NPL ratio for other household or corporate loans beyond those directly for real estate. - If CRE deterioration leads to knock-on effects on related industries or a broader downturn with higher unemployment, banks’ loans to those firms could also come under pressure. - Securities losses: - The analysis does not assume additional losses realized on banks’ holdings of securities. - Bundesbank 2023 FSR noted nearly ⅔ of banks had unrealized losses on securities, amounting to 15 percent of par, due to higher interest rates but not realized because of reclassifications as long-term assets. - During Q1 2024, the Bundesbank estimates that banks’ unrealized losses from securities have declined to ⅓ of its earlier estimate because many securities have gained in market value as they have approached maturity (the a “pull-to-par” effect). - The 1-year horizon may be viewed as rather severe, as this allows only one year of earnings to provide a buffer against loan losses associated with CRE deterioration. - Contagion: - Banks could face contagion risks from other entities, such as insurers or asset management subsidiaries, within the same banking group. - Funding pressures: - The scenario assumes some decline in earnings from their high levels in 2023, but it does not assume a dramatic increase in funding costs, which could arise for some banks in highly adverse scenarios. ### Comparison to the 2023 EBA stress test - 2023 EBA highly adverse 3-year scenario shocks for Germany: - GDP falls cumulatively by 6.4 percentage points. - Inflation rises by 21 percentage points. - Unemployment rises by 4 percentage points. - Residential real estate prices fall by 26 percent. - Commercial real estate prices fall by 33 percent. - In that scenario: - German banks included in the test lose about 6 percentage points in their CET1 capital ratios. - CET1 ratios fall to about 9 percent on average at the end of the scenario horizon. - Such an impact would erode existing macroprudential and systemic institution buffers for most of the banks included in the test. - It is uncertain what impact it would have on other banks, not included in the test, especially those with high exposures to CRE. ### Policy recommendations - Continued close micro-prudential supervision: - Close supervision of banks with high CRE exposure, including in the US, remains appropriate. - Authorities should ensure that banks’ provisions remain adequate for potential losses. - Banks should be conservative with capital distributions, and authorities should exercise their prerogative to restrict such distributions as warranted by potential losses in relation to existing provisions and buffers. - Review of financial safety arrangements: - Authorities should review and test mechanisms for addressing problem banks swiftly (for example, taking prompt corrective action, establishing bridge bank and protocols for public communication, or ensuring timely payout arrangements for deposits). - Consider facilitating swift debt restructuring mechanisms for troubled developers, possibly by deploying online technology to link debtors and creditors. - Assessment of macroprudential buffers: - Authorities should continue to maintain existing macroprudential buffers, including the CounterCyclical Capital Buffer (CCyB) and the Sectoral Systemic Risk Buffer (SSyRB) for loans secured by RRE. - Adding income-related borrower-based measures, such as debt-to -income (DTI) and debt service-to -income (DSTI) ratios for RRE, to the macroprudential toolkit would be welcome. - It is critical to close gaps in CRE data collection with respect to credit underwriting assessments and exposures. - Support for CRE conversions to other uses: - In jurisdictions where the CRE market is under pressure (for example, the United States), there has been a push for conversions of CRE properties to residential use, which remains in demand. - Conversions pose technical, legal, and operational challenges (e.g., retrofit of plumbing and ventilation, zoning restrictions). - Authorities could help support private sector initiatives by reducing administrative and legal requirements, for example in relation to zoning restrictions. ### Medium-term stability and structural reforms - Continue steps to strengthen financial stability and structurally low profitability of banks: - Reduce operational overhead associated with physical offices of many small banks through digitalization of banking services or consolidation. - Consolidation could increase opportunities for income diversification. - A capital markets union (CMU) across the European Union could increase savings from economies of scale and create opportunities for banks to expand sources of non-interest income (for example from investment banking or asset management services). *Source: sipea2024035 - 11. The results from some adjustments to assumptions in the stress scenario are presented* ### 1. Real Estate Price Developments _______________________________________________________ 3 ### 1. Real Estate Price Developments ### Introduction - Structural change in demand and higher interest rates have contributed to weakness in pricing of commercial real estate (CRE) globally, especially for offices and urban retail. - Monetary policy tightening after the pandemic increased refinancing costs and lowered collateral valuations, contributing to borrower difficulties servicing principal and interest on CRE loans. - NPLs related to CRE for German banks rose substantially during 2023, raising credit and market risk concerns for banks and insurers. - Key authority actions recommended by the paper (summarized in findings): continue close supervision of institutions with CRE exposures, ensure adequate provisions, maintain macroprudential buffers, review and test financial safety arrangements, and explore measures to bolster banking system earnings over the longer term. ### Real Estate Developments - CRE indexes from peak in early 2022: - US: down about 21 percent - Germany: down about 17 percent - Euro area: down about 12 percent - German house price index: - Declined some 10 percent from its peak - Had appreciated more than 60 percent over the past decade - Index and cross-country comparison caveats: - Index composition differs (mix of offices, retail, warehouses, multi-family etc.) - Index construction varies (transaction-based vs. rental-yield–based) - CRE loan characteristics differ across markets (loan duration, amortization pace, refinancing exposure) ### CRE Loan Performance and Delinquencies - NPL developments: - NPL ratio on German banks’ CRE loans: rose to 3.8 percent by end-2023 from about 2 percent at the start of the year - NPL ratio on German banks’ CRE loans in the US: rose to 10 percent by end-2023 - Loan-to-value (LTV) averages reported by banks: - US CRE loans: about 80 percent - German CRE loans: 65 percent - Observation: delinquencies have risen but defaults have not increased correspondingly due to banks extending maturities or adjusting loan terms; significant variation exists across individual banks. ### Exposures of Financial Institutions to CRE - Sample of top 15 German banks (excludes German subsidiaries of foreign banks): - For these 15 banks, CRE exposure averages 18 percent of their loan books. - Nearly 2/3 of this CRE exposure is in Germany. - Exposure to US CRE averages nearly 11 percent of their CRE loan books; this US exposure is concentrated in a few large banks. - Composition by lender type: - Large universal banks: higher exposure to multi-family housing loans vs. offices. - Regional Landesbanks, mid-range banks, and specialized lenders: more exposure to office properties. - Performance varies by location (e.g., largest cities vs. rest of country). - Insurers: - CRE exposure averages 8 percent of asset portfolios. - Insurers typically hold physical CRE assets long-term and may still realize long-term capital gains notwithstanding recent price declines. - Stress example: applying a 25 percent decline in CRE prices to insurers’ holdings implies a 2 percent decline in asset valuations, other factors constant. - High solvency ratio of insurers cited as 330 percent (life and non-life combined). - Insurers may also hold equity or corporate bonds issued by CRE-related firms; valuation deterioration for these is less certain given available information. ### Solvency Stress Analysis and Results - Illustrative adverse 1-year scenario assumptions: - CRE NPL ratios: 10 percent on German/EU CRE; 15 percent on US CRE - 100 percent conversion of NPLs to default (in some scenario variants 50 percent conversion is also considered) - Legal/operational costs: 30 percent of the foreclosure price - LTV buffers assumed: 80 percent on German CRE loans; 85 percent on US CRE loans (alternative LTV assumptions explored in scenario variants) - RRE (residential real estate) LTV: 85 percent - RRE NPL ratios in scenarios: 0.8 percent or 1.5 percent (scenario variants) - Earnings shock: 30 percent reduction versus 2023 (to adjust for record 2023 profits) - Results net of provisions; earnings either fully reinvested or excluded in variants; no further realized market losses on securities assumed - Stress exercise findings: - Under the main adverse scenario (NPLs to 10 percent German/EU and 15 percent US, 30 percent reduction in 2023 earnings), three banks out of the 15 in the sample face a capital hit but remain reasonably capitalized. - Scenario sensitivity: different assumptions on NPL conversion rates, RRE NPL ratios, LTV buffers, and earnings treatment affect the distribution and magnitude of CET1 ratio impacts across banks. - Context on earnings assumption: - The 30 percent reduction vs. 2023 earnings partly adjusts for record 2023 profits generated by banks due to policy rate tightening where lending rates rose faster than deposit rates; deposit rate repricing during 2024 could further reduce bank net interest income once fully realized. ### Covered Bonds and Market Risk - Covered bond protections and practices: - Holders of covered bonds are not exposed to credit risk of underlying CRE loans while issuer remains solvent; if issuer defaults, covered bondholders have full recourse to underlying collateral and protection from bail-in. - Legal requirement: at least 2 percent more in nominal amount of loans collateral versus par value of covered bonds issued. - Eligibility: CRE loans eligible as collateral up to 60 percent of a property’s lending value (“Beleihungswert”). - Typical additional bank collateral cushion: often as much as 20–30 percentage points beyond the two percent requirement. - Diversification: banks frequently diversify covered-bond collateral across residential and commercial real estate and must add high-quality liquid assets for liquidity protection. - Market developments: - Spreads on covered bonds widened for some banks during February–March 2024 but largely recovered through early June 2024; corresponding market losses on banks holding such securities have reversed. *Source: IMF staff paper "Financial Stability Risks from Commercial Real Estate" (Germany), July 1, 2024.* ### 11. The results from some adjustments to assumptions in the stress scenario are presented ### 11. The results from some adjustments to assumptions in the stress scenario are presented ### Results of alternative assumptions in the stress scenario - If the assumption on all NPLs going into default is relaxed to allow only half of NPLs to go into default (due as a result of banks working out loan extensions or other proactive restructurings with borrowers to keep them current on loan payments), then the capital impact on banks is less severe, with only one bank facing a capital hit, which is marginal. - Other assumptions that lead to different estimates of potential loan losses and corresponding capital impact include: - LTV cushion on German and US CRE. - The peak NPL impact on German banks’ exposure to CRE. - Potentially higher RRE loan losses. ### Caveats and omitted risks in the analysis - Losses on other types of loans: - The scenario does not assume deterioration in the NPL ratio for other household or corporate loans beyond those directly for real estate. - If CRE deterioration leads to knock-on effects on related industries or a broader downturn with higher unemployment, banks’ loans to those firms could also come under pressure. - Securities losses: - The analysis does not assume additional losses realized on banks’ holdings of securities. - Bundesbank 2023 FSR noted nearly ⅔ of banks had unrealized losses on securities, amounting to 15 percent of par, due to higher interest rates but not realized because of reclassifications as long-term assets. - During Q1 2024, the Bundesbank estimates that banks’ unrealized losses from securities have declined to ⅓ of its earlier estimate because many securities have gained in market value as they have approached maturity (the a “pull-to-par” effect). - The 1-year horizon may be viewed as rather severe, as this allows only one year of earnings to provide a buffer against loan losses associated with CRE deterioration. - Contagion: - Banks could face contagion risks from other entities, such as insurers or asset management subsidiaries, within the same banking group. - Funding pressures: - The scenario assumes some decline in earnings from their high levels in 2023, but it does not assume a dramatic increase in funding costs, which could arise for some banks in highly adverse scenarios. ### Comparison to the 2023 EBA stress test - The 2023 EBA stress test featured a highly adverse hypothetical 3-year scenario for Germany with the following shocks: - GDP falls cumulatively by 6.4 percentage points. - Inflation rises by 21 percentage points. - Unemployment rises by 4 percentage points. - Residential real estate prices fall by 26 percent. - Commercial real estate prices fall by 33 percent. - In that scenario: - German banks included in the test lose about 6 percentage points in their CET1 capital ratios. - CET1 ratios fall to about 9 percent on average at the end of the scenario horizon. - Such an impact would erode existing macroprudential and systemic institution buffers for most of the banks included in the test. - It is uncertain what impact it would have on other banks, not included in the test, especially those with high exposures to CRE. ### Policy recommendations - Continued close micro-prudential supervision: - Close supervision of banks with high CRE exposure, including in the US, remains appropriate. - Authorities should ensure that banks’ provisions remain adequate for potential losses. - Banks should be conservative with capital distributions, and authorities should exercise their prerogative to restrict such distributions as warranted by potential losses in relation to existing provisions and buffers. - Review of financial safety arrangements: - Authorities should review and test mechanisms for addressing problem banks swiftly (for example, taking prompt corrective action, establishing bridge bank and protocols for public communication, or ensuring timely payout arrangements for deposits). - Consider facilitating swift debt restructuring mechanisms for troubled developers, possibly by deploying online technology to link debtors and creditors. - Assessment of macroprudential buffers: - Authorities should continue to maintain existing macroprudential buffers, including the CounterCyclical Capital Buffer (CCyB) and the Sectoral Systemic Risk Buffer (SSyRB) for loans secured by RRE. - Adding income-related borrower-based measures, such as debt-to -income (DTI) and debt service-to -income (DSTI) ratios for RRE, to the macroprudential toolkit would be welcome. - It is critical to close gaps in CRE data collection with respect to credit underwriting assessments and exposures. - Support for CRE conversions to other uses: - In jurisdictions where the CRE market is under pressure (for example, the United States), there has been a push for conversions of CRE properties to residential use, which remains in demand. - Conversions pose technical, legal, and operational challenges (e.g., retrofit of plumbing and ventilation, zoning restrictions). - Authorities could help support private sector initiatives by reducing administrative and legal requirements, for example in relation to zoning restrictions. ### Medium-term stability and structural reforms - Continue steps to strengthen financial stability and structurally low profitability of banks: - Reduce operational overhead associated with physical offices of many small banks through digitalization of banking services or consolidation. - Consolidation could increase opportunities for income diversification. - A capital markets union (CMU) across the European Union could increase savings from economies of scale and create opportunities for banks to expand sources of non-interest income (for example from investment banking or asset management services). *Source: sipea2024035 - 11. The results from some adjustments to assumptions in the stress scenario are presented* --- _Source: https://www.imf.org/-/media/files/publications/selected-issues-papers/2024/english/sipea2024035.pdf_