Luxembourg-based real estate funds are among those identified with potential financial instability in the EU’s commercial real estate sector, as part of a 709-fund sample analysed by the European Securities and Markets Authority. The report, published by the market regulator on Tuesday 30 January, highlighted significant macroeconomic pressures--including elevated inflation, rapidly rising interest rates and a global growth slowdown--impacting the RE funds market. Esma noted that these funds, which have grown by 375% in the past five years, are among the most exposed to risks in the real estate market.
Sector concentration
The Esma analysis included funds representing a total net asset value (NAV) of €578bn and assets under management (AUM) of €851bn, amounting to 56% of the AUM of all EU RE funds. The sector is highly concentrated, with 92% of the assets managed in five jurisdictions: Germany, Luxembourg, France, the Netherlands and Italy. In the estimated EU commercial real estate market, RE funds from these jurisdictions make up 18%, with Luxembourg’s RE funds alone accounting for a significant 22%, or about 4% of the total EU CRE market, underscoring their substantial market footprint.
Leverage concerns
A notable concern raised by Esma is the use of substantial leverage among many RE funds (230 out of the sample), representing only 2% of the total NAV of the sample. The median leverage ratio of RE funds stands at 406%, the lowest among all fund categories in Esma’s sample, with this trend especially pronounced in the largest jurisdictions, including Germany and Luxembourg. Systemically, the aggregated market footprint of RE funds is substantial, managing a portfolio totalling €851bn, of which €445bn are real estate assets. Including all RE funds beyond the ESMA sample, the sector manages €952bn of RE assets, equating to 27% of the EU CRE market.
Liquidity mismatch
One of the key vulnerabilities identified in the report is liquidity mismatches, with a subset of funds exhibiting significant mismatches. The sampled RE funds are most exposed to less liquid assets, with 89% of the portfolio not being liquidatable within 3 months. This discrepancy between the percentage of NAV that can be redeemed and the percentage of assets that can be liquidated over the same period poses a potential risk of contagion to financial institutions. Despite the average mismatch between redemption frequency and asset liquidity being limited in Luxembourg, a subset of funds shows a significant liquidity mismatch, indicating a diverse market composition of open-ended and closed-ended RE funds in the region.
Investor composition and potential risks
Esma noted that the investor base of RE funds is predominantly institutional, comprising 80% at the end of 2022, with insurance and pension funds accounting for 23% and 18% of the NAV, respectively. However, households also play a significant role, owning 22% of the NAV in CRE funds. The risk of contagion to financial institutions is a potential concern if financial stability issues affect RE funds, although spillover risks are lower in funds held by retail investors. This could, however, lead to concerns regarding investor protection. For RE funds with liquidity mismatches, the reliability of commitments from institutional investors poses a significant concern, especially in times of heightened liquidity demands.
Regulatory oversight
In light of these findings, Esma underscored the need for vigilant monitoring and risk management within the RE fund sector. Specifically, in Luxembourg, where RE funds generally exhibit low leverage but hold a significant market share in the EU, the national financial regulator, the Luxembourg Financial Sector Supervisory Commission (CSSF), has been actively monitoring the sector. This includes focusing on liability-driven investment (LDI) funds, which aim to match investment assets with future liabilities, primarily used by institutional investors. The CSSF’s ongoing assessments suggest that risks related to these funds remain elevated, yet the existing limits are deemed appropriate. Furthermore, consultations have been launched to potentially maintain the current 300bp resistance levels as an additional management restriction for AIF on LDI funds.
Concluding the report, Esma indicated it will further assess the need for issuing advice to national competent authorities to address the identified financial stability risks, based on the information received from them.
The 22-page report is available .