German Pfandbriefe offer greater investor protection than any other covered bond regime, so despite their heavy exposure to commercial real estate, where prices are expected to fall further, the bonds are unlikely to suffer.
At the end of the first quarter, German commercial property prices were down 8.3% from the same period in 2022, according to data from the Association of German Pfandbrief Banks (vdp). Prices in the retail sector were down by 10.5%, outpacing the 7.5% year-on-year price fall in office properties.
Around one quarter of Germany’s 30-odd Pfandbrief issuers have exposure to the commercial real estate market, amounting to around 75% or more of their cover pools.
Among these, Aareal Bank and Deutsche Pfandbriefbank (PBB) have the highest exposures to countries outside Europe, principally in the US, where CRE prices have fallen the most.
However, Pfandbriefe offer investors plenty of protection, insist market insiders. “Pfandbrief is really something that funds through the cycle as haircuts [of the loans that go into the cover pool] can be up to 80%, depending on what’s being financed,” says Frank Finger, Aareal Bank’s head of treasury, in Dusseldorf.
On average, there is a 30% difference between the market value of a commercial property and its mortgage lending value (MLV), which is prescribed under Pfandbrief law. Furthermore, only 60% of the MLV can be put into the cover pool.
If property prices go up during the term of the loan, issuers cannot revalue the cover pool at a higher level to take out more debt. When a loan is refinanced at the end of its term, the originating bank can use a higher MLV if prices have risen.
Collectively, these mechanisms give investors a lot of protection, thought to be the highest of any covered bond regime.
The average LTV of Aareal’s loan portfolio was 55% at the end of March and its NPL ratio was 3.4%. In PBB’s case, the weighted average whole loan to value of its portfolio was 51%, its NPL ratio was 1.6% and its weighted average interest cover ratio was 300%, as of the end of March.
The two issuers’ portfolios contrasted with Berlin Hyp’s, which largely comprises mortgages on German and Dutch commercial properties. At the end of March, its portfolio had a similar LTV of 54%, but thanks to its more conservative underwriting standards and early focus on green buildings, the NPL ratio was just 0.4%. Within BHH’s loan portfolio of offices, half the loans are green, which differentiates it from other lenders.
Year-on-year and quarter-on-quarter change in prices
No equilibrium yet
But the question for many people is where the CRE market is heading and what the impact will be on mortgage lenders’ portfolios.
Sascha Kullig, a member of the management board of the Association of German Pfandbrief Banks (vdp) in Berlin, says there have been comparatively few commercial loan transactions in Europe, making it difficult to estimate the impact on cover pools.
“People who want to sell are unwilling to accept large price declines and companies with interest to buy are hoping for a more substantial discount,” he says. “As such, a price equilibrium has not yet been reached and this explains why there’s been so few deals.”
Finger says a repricing of commercial property is not far off but it has not happened yet. “I don’t expect interest rates to go much higher and, before long, they will plateau and we’ll see a period of [rates] stability which should help to catalyse new deals and a new level of [loan] pricing,” he says.
Even so, Bodo Winkler-Viti, BHH’s head of funding and investor relations in Berlin, says there is still “a high level of uncertainty” about where prices and rates will go, He thinks transaction volumes will only begin to grow after prices have been recalibrated.
Kullig agrees with this view and draws attention to the ambiguous economic backdrop for inflation and the economy, which makes it “difficult to predict how markets will react”.
Despite this, Kullig is optimistic about German commercial property income. “The good news is that rents have increased by 4.7% year on year and vacancy rates are still low,” he says.
Property valuations can also vary depending on their use. One of the most pertinent factors is how the structural shift in working from home arrangements has taken hold since the pandemic.
Kullig says people are clearly working fewer days in the office but this trend might be offset by other factors, such as the need for more space, higher quality buildings and better locations.
More desirable, energy efficient buildings are one example. Conversely, incoming regulations on the sustainability of older buildings raise the risk that “investors are left holding stranded properties” in some grade ‘B’ office assets located in less popular locations, says Antonio Farina, a Madrid-based director at S&P, in charge of its sustainable covered bonds business.
Another Pfandbrief funding official, who prefers to remain anonymous, backs up this view and says that office prices have become a “big discussion point”, particularly in the US where a repricing has already taken place. He says the US CRE market is “brutal” and anticipates a wave of loan restructurings.
The funding official says the biggest risk that lenders face is “exit risk” — that a borrower cannot refinance a loan due to higher rates, or cannot sell a property without taking a loss.
For this reason, Finger says it is critical to maintain close contact with loan borrowers or sponsors. A sponsor’s commitment is a key determinant of a loan’s performance, he says.
In challenging times, three fundamental factors must be assessed, says Finger. “That’s location, the quality and attractiveness of the building, as well as the professionalism of the customers to adapt real estate to new demands of the market.”
Winkler-Viti agrees that modern, energy efficient buildings are likely to be much easier to manage than buildings needing investment.
Rolling over
Stuck with falling prices and an inability to sell, sponsors tend to roll over and extend their loans. The Pfandbrief funding official says his firm has seen a big uptake in loan extensions. This involves borrowers taking out a shorter duration loan on less attractive terms in the hope that market conditions improve by the time it matures.
Due to these problems, one German investor buying Pfandbriefe for his bank’s liquidity coverage ratio portfolio says he has been taking a much keener interest in the mortgage portfolios of Pfandbriefe.
He says the 10bp-20bp additional spread that Aareal and PBB’s Pfandbriefe pay over stronger credits is warranted for the additional risk of their loan portfolios.
“The pick-up is what I expect and I ask the issuer to pay for the risk I’m taking in their CRE cover pools,” he says. “And even though they have low NPLs, I’m taking a closer look, as they can only get worse.
“Ultimately, it is a question of how much capital and other income these banks have to cope with losses, and from that perspective I think they are well capitalised and well-funded.”
As of June 2023, PBB reported total assets of €49.8bn, a common equity tier one ratio of 16% and net income of €69m. PBB group reported aggregate losses of €5m from operation risks during the first half of 2023.
In the same month, Aareal reported second quarter total assets of €49bn, a CET1 ratio of 19.4% and consolidated net income of €58m. Aareal said its loss allowance was likely to be in the range of €270m-€330m, up from a forecast range of €170m-€210m, largely due to the US office property market. The bank expects to make an operating profit of €240m-€280m, up from €239m in 2022.
The same investor expressed confidence in Pfandbriefe but acknowledged that senior unsecured notes were likely to become more vulnerable to a CRE repricing.
S&P’s Farina expects European banks’ funding costs to rise over the rest of the year and next, as deposit availability is expected to decrease as central banks accelerate their balance sheet reduction. “Banks are generally well funded and capitalised and have capacity to increase exposure,” he says. “[But their] willingness to [increase exposure] is problematic.”
He thinks banks are more willing to help existing clients than take on new risk, despite the fact that opportunities are starting to appear.
The Pfandbrief funding official says borrower access to funding has become more restricted. “They don’t get funding, but on the other hand, there are huge opportunities for new business with low LTVs and high margins as there’s less competition,” he says.
OC and risk planning
NordLB and Aareal Bank have both increased their CRE exposure by 10%-15% from last year, while Aareal has increased its exposure to multi-family housing by almost 30% from 2022, according to S&P.
As of December 2022, Aareal’s €15.1bn Pfandbrief cover pool contained 491 commercial loans with a value of about €14bn, of which about half were in euros, 27% in dollars and 15% in sterling with a weighted average LTV of 55.8%, says Moody’s.
Aareal’s overcollateralisation (OC) ratio was 20.7%, only slightly above the 17.7% required for a Aaa rating from Moody’s.
Deutsche Pfandbriefbank’s €19.3bn cover pool contained 1,487 commercial loans worth €18.7bn as of March. Of those, 70% were denominated in euros, 17.7% in dollars and 8.4% in sterling with a current weighted average LTV of 47.3%, said Moody’s.
Its OC ratio was 31.2%, well above the 12.5% needed for its Aa1 rating from Moody’s.
Excess OC, above the amount required for an issuer’s Pfandbrief rating, averages around 25pp across the Pfandbrief sector, according to Commerzbank. As such, Aareal’s excess of 3% is conspicuous for being by far the lowest.
Other issuers “could thus still draw on this leeway, at least in part, without jeopardising their credit rating,” says Ted Packmohr, head of covered bond and financials research at Commerzbank in Frankfurt, who adds that prudent management of OC is a natural part of banks’ issuance planning.
“Maintaining a high level of rating stability is part of good practice in the covered bond market, not only in Germany,” he says. “We therefore assume that the banks will tailor their issuing activity to their OC capacity without this resulting in substantial credit risks.”
Aareal has visited the covered bond market three times this year, raising a total of €2bn, and has issued €2.65bn in benchmark format over the last year. Deutsche Pfandbriefbank has visited the covered bond market twice this year, raising €1bn in total and €2.25bn since July 2022.
