The European commercial real estate (CRE) sector has faced significant challenges in recent years, driven by shifting working patterns caused by the pandemic and rising interest rates. In 2022 and in the first half of 2023, we have seen meaningful volatility and sizeable widening in credit spreads for bonds issued by real estate companies.
In recent months, the sector has seen a meaningful tightening in credit spreads, although not yet to levels comparable to 2021. This is largely due to improved investor sentiment and a revised outlook on interest rates, rather than any major shift in the underlying fundamentals of the issuers. This more benign market backdrop has opened the door for many companies, like Vonovia and Logicor, to access the bond market again, with strong investor demand leading to reduced premiums on new issuances. This trend of increasing bond issuances could continue, as companies seek to shore up liquidity and manage debt maturities.
However, looking deeper, the picture within the sector is not uniform. While residential and logistics properties are expected to perform better, further valuation declines are expected in the office sector where occupancy remains subdued, partly driven by the pandemic’s work-from-home trend significantly impacting office demand. While higher-quality issuers are returning to the bond market, lower-quality ones remain locked out, facing potential credit restructuring.
We are cautiously optimistic about the sector’s recent rally, but we remain careful with credit selection which continues to be based on rigorous bottom-up credit analysis. Key considerations include: strong asset quality, solid liquidity, ample amount of unencumbered assets, manageable debt maturities, and prudent management practices. In addition, the issuers’ ability to generate cash flow even with higher interest expenses remains a crucial factor in our investment decisions.
How exposed are European banks to the crisis?
European banks have significant exposure to the CRE sector, estimated at around €1.4 Trillion. However, the majority of banks’ CRE exposure is concentrated in the German and Nordic banking system, which means that any widespread defaults or losses could trigger financial instability within the wider banking space. This has raised concerns in the market about a potential domino effect, similar to the 2008 financial crisis.
The recent sell-offs within financials, particularly those exposed to commercial real estate (CRE), were triggered by larger-than-expected CRE provisions reported by US banks. This fear spread to Europe, where smaller German lenders, like Deutsche Pfandbriefbank, saw significant share price drops due to their high US exposure. Despite PBB’s attempts to reassure investors, their heavy CRE exposure and declining capital buffers raised concerns. We expect continued pressure on small German banks and US regional players.
However, contagion risk to other European banks seems limited. Major banks like Barclays, Société Générale, and Crédit Agricole have low US CRE exposure. Even higher-exposure banks, like Unicredit, are cushioned by strong capital and a low-risk portfolio. Irish banks, with a larger property exposure, focus primarily on domestic residential and retail, mitigating concerns. Overall, while individual cases warrant monitoring, the broader European banking system appears less susceptible to the current US CRE issues. At Jupiter, across our fixed income strategies, we have minimal exposure to banks with large CRE portfolios. It is important to note that we have no exposure (not even at senior level) to the banks mentioned in the second paragraph.
Looking ahead
The future of European CRE remains uncertain. The health of the European banking sector is intricately linked to the CRE market, and any significant losses could have wider repercussions. Although we believe that most large European banks are sufficiently capitalised and insulated from volatility in the CRE market, smaller banks could be more exposed. We continue to highlight the importance of fundamental analysis of individual sub-sectors and issuer fundamentals is crucial for navigating this complex and evolving landscape.
The value of active minds: independent thinking
A key feature of Jupiter’s investment approach is that we eschew the adoption of a house view, instead preferring to allow our specialist fund managers to formulate their own opinions on their asset class. As a result, it should be noted that any views expressed – including on matters relating to environmental, social and governance considerations – are those of the author(s), and may differ from views held by other Jupiter investment professionals.
Important information
This document is intended for investment professionals and is not for the use or benefit of other persons. This document is for informational purposes only and is not investment advice. Market and exchange rate movements can cause the value of an investment to fall as well as rise, and you may get back less than originally invested. The views expressed are those of the individuals mentioned at the time of writing, are not necessarily those of Jupiter as a whole, and may be subject to change. This is particularly true during periods of rapidly changing market circumstances. Every effort is made to ensure the accuracy of the information, but no assurance or warranties are given. Holding examples are for illustrative purposes only and are not a recommendation to buy or sell. Issued in the UK by Jupiter Asset Management Limited (JAM), registered address: The Zig Zag Building, 70 Victoria Street, London, SW1E 6SQ is authorised and regulated by the Financial Conduct Authority. Issued in the EU by Jupiter Asset Management International S.A. (JAMI), registered address: 5, Rue Heienhaff, Senningerberg L-1736, Luxembourg which is authorised and regulated by the Commission de Surveillance du Secteur Financier. No part of this document may be reproduced in any manner without the prior permission of JAM/JAMI. 288