Europe is notoriously known for the fact that its member states love to agree that they disagree on all important matters concerning the bloc. Ranging from monetary policy to support for Ukraine or even the shape of bananas, EU policy is almost always guaranteed to cause great divergence of opinions in Brussels.
However, there is one single issue all 27 member countries unanimously agree on: The lack of (affordable) housing in our major cities. While the smart cookies of national politics and local city councils have been shouting this from the roofs since a long time, the matter is getting out of hand further in recent months. As an example, the German government set out a goal to provide new housing supply of 400,000 units each year, but has failed doing so in each of the last three years (with a dire outlook heading for 2024).
In this article, we will have a closer look at the state of the residential real estate industry, particularly the development sector and get to the bottom of current challenges as well as likewise explore how a viable path to a solution can look like.
The music for residential developments has stopped playing
Deus ex machina is a Latin calque from Greek and loosely translated as 'god from the machine'. The term was coined from the conventions of ancient Greek theater, where actors who were playing gods were brought on stage using a crane. The installation was used to resolve the conflict and conclude the drama.
In real estate terms, the vast number of construction cranes that fueled a building boom in every city center and neighborhood in the halcyon days of the last several years, with exemplary projects such as the ‘Europa Allee’ in Frankfurt, have drawn their powers not from the gods, but rather cheap financing conditions and strong market value increases. This supportive backdrop created a flywheel whereby successful developers could use their profits (or proceeds from forward sales) as down payment for their next project and hence a flywheel to print money was born. The perfect champion of this model has been Evergrande, once China’s 2nd biggest developer with a market capitalization north of €50 billion, but who has since lost 99% of its value. In the financial sector, there is a belief that as long as the music is playing, you cannot help yourself but have to get up and dance.
As the concert started to come to an end in the last 24 months given the immense adversity in economic conditions real estate developers have been exposed to, it is not uncommon to see already launched construction projects to get halted these days with building cranes in midst of empty construction sites.
The perfect storm has arrived: Explosion of construction cost and interest rates
If there are two input factors the construction industry is most sensitive to, it is construction cost and interest rates. If both hit you adversely at the same time, nothing good is guaranteed to come out at the other end.
Since 2015, blended construction cost have increased by ~40% according to Eurostat, with increases in the main urban metropoles even greater. If looking at the change between 2021 and 2023 alone (assuming a lead time of 2 years for a multifamily construction project), the increase comes to about 30%. As developers target a profit level of 10-20% on top of their all-in cost, you do not need to be a math wizard to conclude most of the projects planned and submitted for application 2 years ago will simply not see the light of day. Data is supporting this assumption with ~25% of German residential projects being cancelled after having been previously permitted already.
As far as interest costs are concerned, 2021 has marked a watershed moment. Whilst it was practical to assume a 1.50% construction loan interest in 2021 (+200bps over Euribor), the same spread equals an all-in cost of ~6.00% today after an increase of +4.5% in the EURIBOR between February 2021 and January 2024. This has several fatal consequences, all of which contribute to the fact that real estate developers find themselves on the wrong side of the land slide more often than not:
a. Residential real estate has been tightly priced in recent years given its ascribed status as safe investment haven. Net initial yields (the yield on a real estate investment before financing cost) have been as low as 2.80% back in 2021, respectively 1.40% after financing cost of 1.50%. A logical consequence in face of low running yields is that refinancing these residential projects post construction has not provided an attractive alternative by developers, but rather selling these apartment units for a 10-20% one-off profit was the preferred game plan
b. Subsequently, as mortgages / loans are now priced closer to 6%, home ownership has become less affordable, which puts developers under increased pressure to realize sales proceeds that are required to repay the initial construction loan
c. Even if developers are able to find a borrower to refinance their construction loans as maturities are coming due, a 2.8% net yield minus 6% financing cost creates a negative leverage effect! This cannot be underscored enough: Apartment complexes that are 100% fully rented and in state-of-the art condition, will create negative running returns for their developers
d. Inflation did not just increase interest rates on construction loans and mortgages but, also manifested higher cost of capital requirements for investors.
If we assume to buy a multifamily property with 10x apartments of 50m² each, rented at a rate of 10€/m² after expenses, the investment creates €60,000 of annual operating income. In order to own this stream of cash flow, we need to pay the seller 30x the annual rental income (i.e. 3.33% yield close to the 2.8% observed in 2021), or €1.8 million. If we grow operating income by 3% a year and sell the complex at the same 30x multiple again, we have created a profit of €1.2 million over the 10-year lifetime or a 6.1% IRR, not bad! Discounting this stream of cash flows at a discount rate of 5% which is fair to assume for a conservative pension fund looking for a core deal, this equals an NPV of €159,000. Conversely, if we increase our discount rate by 3% to 8%, the project unfortunately turns out to have a negative economic value of €240,000. You can now just imagine what the world looks like for Private Equity type buyers with return hrudles of 15-20%.
The fictional example made here is very real and can be observed in the performance property stocks across Europe, which are in fast decline.
The headaches are shared by borrowers and lenders like
In the above chart, we can see that European property stocks are down anywhere between 33%-50% since 2021 across the board. If we assume now a developer has started a construction project in 2021 at an assumed exit value of €100 million and financed it with €70 million debt (=70% loan-to-value), his maturity in 2024 presents several issues.
As a matter of fact, a 33% decline in property value assigns a new value of €67 million to the project, which means the developer’s equity is wiped out completely and the bank realized a €3 million impairment on its loan even if the development is fully leased and considered of prime quality!
Luckily, there are several solutions to avoid this outcome (but are very much kicking the can down the road):
a. The developer / owner can refinance his loan with a new long-term financing agreement. If we were to place again a 70% loan-to-value ratio on the new property value of €67 million, this creates a loan balance of €47 million and subsequent equity need of €20
million to bridge the gap. The problem here is that as explained above, developers operate on thin margins and low equity ratios, hence most will likely not have the required equity check on hand and are forced to declare bankruptcy followed by handing back the keys to the apartments to the banks.
b. Today in Germany, home to the largest institutional stock of multifamily in Europe, private housing companies own about one-quarter of rental dwellings. As it is in the nature of many institutional investors to hold their assets in closed-ended funds, by the time a refinancing with additional equity contribution is coming up towards the end of the fund’s lifetime, these vehicles will have fully deployed all of their dry powder already and equally have to hand back the keys to their lenders via means of default.
Is banking stability in danger?
Deposit-taking banks in the European Union are strongly regulated by the ECB to maintain a certain equity ration (CET-1) in order to create a substantial loss absorption buffer in case of write downs and to ensure depositors can feel safe to receive their money back.
Painting a picture now whereby we claim the meltdown in real estate valuations could cause a systemic shock to the banking sector, feels very much like a Cassandra moment, a character in Greek mythology cursed with the ability to make accurate predictions that no one believed.
First of all, it has to be mentioned that real estate lending across Europe is not a portrait painted with a single brush – countries with high shares of fixed-rate mortgages are considered to be better protected than countries where borrowers pay interest based on a floating rate, i.e. countries like Finland and Spain have a higher risk exposure than Germany or France.
Nonetheless, as real estate (residential + commercial + construction + others) account for >40% of loan books at European banks, potential write-downs have to be closely monitored ahead of time.
Thus far, instead of demanding a repayment of the loan amount at maturity, banks tend to collaborate with borrowers on extending the original maturity under re-negotiated terms. While the industry calls this “amend & extend”, many market participants prefer the term “pretend & extend”: In our above example, where the property decreased in value down to €67 million while there is a €70 million outstanding loan held against it, a bank would take possession of this asset and try to sell it in order to recover its loan. Yet, in a transaction market that is essentially non-existent and the likely fire sale value materially below the €70 million mark, the bank would need to realize a huge loss on its position. Alternatively, by extending the maturity for the borrower, the bank can avoid writing down this loss in its books, an option the borrower welcomes as he will have the chance to sell the asset later down the road to recover some equity when markets have hopefully improved (while continuing to serve interest payments up to this point).
What I have described above as a drastic theoretical situation is already seeing numerous case studies in the commercial real estate space – where NPL rates of commercial mortgages drastically exceed the NPL rate of other loans – while residential real estate seems to be less at risk to date. The ECB shares the opinion that banks have sufficient equity buffers to absorb eventual losses (aggregate Common Equity Tier 1 ratio of 15.72% in Q2 2023), but I guess it is always better to be safe than sorry …
How can we improve the situation?
While we focused for large parts of this article about the risks boiling up in the real estate market, it begs the question how we can improve the situation. Greek theatre used deus ex machina to provide an artificial or contrived solution to an apparently insoluble difficulty. In similar fashion, we want to dedicate this last section to focus on practical solutions:
a. While transaction markets are still very much muted with prices stable at best, the interest and inflation outlook are much more constructive than a year ago. Residential markets have an in-built advantage that as unexpected as demand shocks appeared after a surge in mortgage cost, as fast the market can recover again once the situation becomes more benign. Opposed to that, commercial real estate fights a much prolonged ‘frog in the cream’ battle as commercial leases are usually conducted on 5-year terms where every year only a handful of leases are rolling off, hence delaying the bottom of the market and slowing a subsequent recovery.
b. Much of the squeeze that developers are experiencing is caused by the long lead times from land acquisition to project completion. Significant parts of a project are planning and permission works which are much more onerous in Europe than elsewhere. If governments start introducing measures to speed up the key administrative processes, projects are less exposed to cycle risk and can be executed under more predictable economic conditions
c. If you run around your beach town making everyone believe a hurricane is about to hit the coast, no one will go down to enjoy themselves at the beach even though there is no sight of a hurricane just yet. Metaphorically speaking, governments have created a lot of uncertainties about affordable housing regulations, rent price caps and energy efficiency requirements. As long as developers have no certainty about timing and costs of such measures, they will not dare to conduct meaningful construction activity. Once governments can communicate clear about the regulatory environment, construction activity will pick up again. Similarly, existing stock that is bound for redevelopment must be able to enjoy relaxation to certain standards, which will help to bring more supply to the market quickly.
d. Underwriting real estate construction as a lender is not for the faint of heart. Financial regulators need to instill absolute confidence into the banking sector’s ability to absorb potential losses related to real estate-linked loans. Once depositors become nervous, banks can go belly up within a matter of weeks – or as seen with the example of SVB, even a matter of a single weekend.
