September 2020 – Short-time work, economic slump, and the fear of a wave of insolvencies in 2021: In view of this economic chaos, the comparatively stable situation on real estate markets to date is surprising. But how will the sector and its subsegments – residential, office, and commercial properties – fare in future? In an interview, Peter Axmann, Head of Real Estate Clients at Hamburg Commercial Bank, provides a market forecast.
Mr. Axmann, the coronavirus pandemic has Germany firmly in its grip. While it is true that signs of a recovery are increasing, the latest forecasts from the Federal Government predict a contraction in gross domestic product of 5.8 percent for 2020. How severely will banks financing real estate be affected if city centers are suddenly deserted, shopping streets empty, and hotels closed?
Although the coronavirus crisis has already lasted half a year, the impact on real estate financing has been limited. The government countermeasures initially cushioned many negative effects. That is likely to change in 2021, when the consequences for the real economy will become much more evident. In addition, the subsegments of the real estate market are affected very differently. While the residential asset class is fairly resilient to the crisis, the effects for offices and hotels are not yet foreseeable. For the non-food retail sector in particular, forecasts are gloomy.
As a major real estate financer, isn’t that more than a little unsettling for you?
What is important is that banks – particularly real estate financers – are now much better prepared for economic turbulence than they were in 2008. After the financial crisis, financial institutions gradually built up their capital buffer and increased their common equity tier 1 capital ratio, according to information from the European Banking Authority (EBA), from an average of nine percent to a current rate of 15 percent. At Hamburg Commercial Bank, the CET1 ratio on 30 June 2020 was over 20 percent. Credit standards were also tightened, and financing structures were more conservatively designed. This is also evident in loan-to-value ratios (LTVs).
What does that mean?
LTVs express the ratio of a loan to the market value of the real estate. Prior to 2008, in Germany they frequently stood at 80 percent or more; at the outbreak of the coronavirus crisis, they were much lower at an average of 60 to 65 percent. In other words, real estate financers like Hamburg Commercial Bank now have considerably greater buffers to cushion a potential fall in market prices affecting real estate for which a mortgage has been issued. At present though, very few negative consequences have been seen in financers’ books. This is thanks in part to the extensive measures taken by the Federal Government to cushion the crisis: insolvency moratoriums for companies, rent moratoriums for private renters, instant assistance from the KfW development bank, and money for short-time workers. All of these instruments are contributing to the ongoing payment of rents and, consequently, the interest and debt servicing capacity of owners. In cases in which borrowers have not been able to make payments that are due – for example, because a hotel had to remain closed during the coronavirus pandemic and was therefore unable to generate income – suspensions of redemption payments, in particular, were agreed. These payment deferments do not have a negative impact on the institutions’ earnings situation, provided that payments are made at a later date as agreed.
But this is no guarantee that things will always be so tranquil.
You are right about that. The situation may change rapidly when government measures end. For instance, from the fourth quarter of 2020, there may be more tangible impacts for the real economy, which would then have a delayed effect on banks too. An increase in value adjustments and losses is not unlikely – but it is currently hard to predict their scope.
Against the coronavirus backdrop, what is the situation with respect to new business?
The effects on new business are considerably greater. The purchasing and selling of real estate – and thus also demand for financing – declined significantly in the second quarter of 2020. There were practical reasons for this initially: Market participants were unable to travel to viewings, and authorities and notary’s offices were closed or were only working to a limited degree. Now, however, the low volume of transactions is primarily due to the high level of uncertainty about prices. As very little real estate is being sold, there are not many reference points to establish an appropriate market price. In consequence, market participants often have differing price expectations. Sellers generally want to sell at “pre-crisis prices,” whereas buyers want to negotiate a discount as a result of the crisis. Often the result is that no transaction occurs and both parties bide their time. The financing banks are also affected by this. They are also uncertain as to the correct market value of real estate to some extent. An LTV of 70 percent could quickly become 80 or 85 percent if prices fall and the market establishes itself at a lower level. To preclude this risk, banks are now generally asking for a higher proportion of equity than before the start of the pandemic.
Let’s look more closely at the individual segments within the real estate market. People need living space – that hasn’t changed as a result of the coronavirus pandemic, has it?
It’s true that the housing segment has so far weathered the crisis very well. Rent defaults have increased only marginally, and the transaction market has advanced most along the route to normalization. Experiences from other crises are currently being confirmed: Residential real estate is relatively crisis-resistant, partly because the act of renting to a multitude of tenants lowers risk.
Let’s turn to retail – and perhaps the biggest problem?
The situation in the retail segment is varied. Food retailers are clearly emerging from the crisis among the winners, but the prospects are gloomy for shopping malls, warehouses, and in some cases high-street properties. Even before the pandemic, this last group had come under pressure from increasing online trade and a change in shopping behavior. The crisis has further accelerated this development. The non-food retail sector cannot be expected to achieve the sales and footfall seen before the crisis over the coming months and years. The outlook is particularly negative for real estate where it is not possible to alter the usage concept to reflect the change in purchasing behavior.
What about hotel properties?
The lockdown lasting several months hit the hotel industry hard. Capacity utilization dropped to nearly zero from one day to the next. A minor but steady recovery is now evident. I am cautiously optimistic in the long term, because people will not want to forego travelling permanently.
And should office property investors do in your opinion? Live in hope or fear?
Developments with respect to office property are the most difficult to predict. We have not seen any major losses in this segment to date. Even if tenants are affected by the coronavirus pandemic, they are currently generally paying their rents. However, this may change if the consequences of the crisis have a major impact on the real economy, leading to insolvencies. Experience has shown that it takes twelve to 18 months for the office market to react to an economic crisis. It is still unclear whether as many people as at present will continue to be able to or to want to work from home – or even whether the increasing amount of space needed per workplace due to the coronavirus distancing regulations will leave space consumption almost unchanged despite a lower number of workers in open-plan offices. It is likely that there will be more considerable differentiation in the office segment once again. Core real estate will remain in demand, whereas category B, C, and D cities, as well as peripheral locations, will feel the consequences more keenly.
When will everything return to normal?
It will take some time; we are only at the start of the recovery. Local outbreaks of the virus show how quickly the situation can change again. However, it seems clear that the return to a semi-normal market situation will not occur in the short term but will take at least two years. But – and this is important – real estate will remain a sought-after asset class given the good economic and legal framework conditions in Germany.