“Demand for loans is cooling exceptionally quickly and loan losses are starting to rise, albeit from low levels. The ongoing correction in real estate markets--both commercial and residential--may compound these dynamics,” said Luis de Guindos, vice president of the European Central Bank, in the introductory remarks of the semi-annual flagship financial stability review, published in November. De Guindos is seen here during an ECB’s press conference, 14 September 2023. Photo: European Central Bank

“Demand for loans is cooling exceptionally quickly and loan losses are starting to rise, albeit from low levels. The ongoing correction in real estate markets--both commercial and residential--may compound these dynamics,” said Luis de Guindos, vice president of the European Central Bank, in the introductory remarks of the semi-annual flagship financial stability review, published in November. De Guindos is seen here during an ECB’s press conference, 14 September 2023. Photo: European Central Bank

Escalating geopolitical tensions, tightening financial conditions and a cooling real estate sector, marked by falling commercial and residential property prices and rising debt service costs, are key concerns in the European Central Bank’s latest assessment of euro area financial stability.

Between May and August 2023, €6bn in European commercial real estate bonds were downgraded to high yield, with an additional €10bn facing risk, alongside a 10% year-on-year drop in property prices in the second quarter--the largest decline since 2006--highlighting the significant financial strain faced by the sector, revealed the European Central Bank in its latest financial stability review. on 22 November 2023, this semi-annual assessment of euro area financial stability painted a concerning picture of the economy and financial situation.

Commercial real estate markets

A critical focus of the report was the real estate sector, where both commercial and residential markets showed signs of strain.

The commercial real estate market, already reeling from a downturn, faced further challenges. CRE prices had been declining, with market activity subdued, leading to difficulties in price discovery. Specifically, demand for office space saw a sharp deterioration in Q2 2023, notably in the non-prime segment. This downturn significantly led to the underperformance of real estate firms’ stock prices against the overall market.

Moreover, transaction activity in CRE markets plummeted by 47% in the first half of 2023 compared to the same period in 2022. This downturn has prompted significant credit rating activity, with S&P downgrading 22% of European real estate firms since 2022, and a further 26% on negative outlook. The ECB noted that €6bn of bonds issued by European real estate firms were downgraded to high yield between May and August 2023, with an additional €10bn in bonds remaining vulnerable to a ratings cut.

From a systemic risk perspective, the ECB noted that adverse CRE market outcomes alone were unlikely to push the euro area banking sector below minimum capital requirements. However, a significant deterioration in CRE asset quality could challenge banks more exposed to CRE loans.

Residential real estate

In the residential real estate sector, the situation is equally challenging. The first half of 2023 saw a cooling of the euro area RRE markets, with prices starting to fall in several countries. Borrowing costs have risen steeply, negatively impacting mortgage demand and leading to a sharp decline in new lending. This decline is also reflected in weak construction confidence and a significant drop in the issuance of new residential building permits. Despite these price declines, the ECB anticipates further ‘downside risks’ to valuations, indicating the potential for further price falls.

Household debt and employment

The report also highlighted the dual impact of a strong labour market and rising debt service costs on euro area households. Although employment levels are at record highs and wages are rising, consumer confidence and households’ financial situations worsened after July 2023, remaining below pre-pandemic levels. Moreover, the real compensation per employee fell substantially in 2022, but negotiated wages have picked up significantly recently.

The household vulnerability indicator stands below its long-run average, reflecting a generally sound financial position. However, deteriorating debt servicing capacity due to higher policy rates is a growing concern, ECB noted. The report stated that from Q1 2022 to Q2 2023, the share of households with a debt service-to-gross-income ratio above 30% increased from 12% to 14%. This increase is more pronounced in countries with a higher share of variable-rate mortgages.

Policy implications

The central bank report emphasised the need for robust macroprudential policy measures to address these emerging vulnerabilities. While most euro area countries have implemented measures for RRE, actions targeting CRE have been limited. The report noted that by mid-2023, 15 of the 20 euro area countries had implemented borrower-based measures and ten had targeted capital-based measures for RRE vulnerabilities. In contrast, the complexity of CRE markets has made it difficult to design effective policy responses.

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