(Bloomberg) -- As fears about US commercial real estate roiled German banks this month, their message was clear: don’t worry, the vast majority of our property exposure is domestic. 

That may not prove the comfort it seems.

While the country has so far avoided the rapid market corrections that rattled the US, experts argue that reflects arcane accounting practices shielding its lenders and investors from taking immediate hits. Relatively modest adjustments and benign provisions obscure the fact that German lenders are more exposed to commercial real estate than most of their European peers and, according to one study, extended loans more aggressively.

The result is a slow-motion property crash that threatens to accelerate as property owners such as Rene Benko’s Signa group of companies or landlord Adler Group are forced to sell, burdening smaller and mid-sized lenders that were just hitting their stride after bail-outs in the financial crisis. Some senior officials at the European Central Bank say the country will inevitably be a special focus as they examine CRE risks at banks across the region.

“This is definitely not just a US problem,” said Valeriya Dinger, a professor of economics at Germany’s University of Osnabrueck. “I wouldn’t be surprised if we see a wave of loan loss provisions for German banks on their domestic commercial real estate exposure,” she said, even if there’s no systemic risk.

German banks have the most commercial real estate loans in the European Union, along with their French peers, but they have classified a relatively small portion of those loans as non-performing. Recently, however, that share has been rising while it declined in several other countries.

The low level of loans marked as non-performing is in part because real estate valuers in Europe’s biggest economy use a long-term approach that smooths shifts in pricing on the basis that most investors don’t sell in a falling market. German banks also update valuations of buildings they have financed less regularly than peers in the US or UK, so problems can be masked for longer. Sometimes, they offer measures such as quarterly waivers on breaches of the loan agreement.

“There is nowhere to hide a covenant breach in the US,” said Keith Breslauer, founder of private equity firm Patron Capital Advisers. “That’s just not the case in Germany.”

Visibility is reduced further by rules that give smaller banks leeway in marking some securities to their market value, which can make it more difficult for investors to get an up-to-date picture of their financial state. The practice, however, also limits writing up unrealized gains, meaning individual lenders may actually be in better shape than they look.

Regulators have been urging lenders to prepare for potential losses, with the ECB pushing them to use some of last year’s bumper profits to build provisions. But accounting rules designed to stop banks from dodging taxes mean lenders are actually limited in how much they can set aside for souring debt.

Local watchdog BaFin for now sees the problem hitting individual lenders’ earnings, rather than threatening their solvency, in part because the troubles are concentrated in a smaller part of the market than they were during the financial crisis. And while higher rates are to blame for falling CRE values, they’ve also handed banks profits that should help absorb hits, said Birgit Rodolphe, executive director for bank resolution at the regulator.

“Commercial real estate is a lot smaller than residential real estate and the part of the cake that’s under pressure is smaller still,” she said in an interview at her offices in Frankfurt. “Also, it’s not like they’re holding worthless paper like back in 2008, there are buildings behind these loans.”

The value of those properties, however, remains the subject of much debate as the gap widens between the prices buyers are willing to pay and those sellers need so they can repay their loans. That’s a particular challenge in Germany, which tends to rely on actual transactions for real estate valuations, rather than sentiment-based inputs as is the case in some other countries. 

An index published by German banking group VDP showed office values dropped 10% last year, the most since it began collecting the data in 2003. That index is based entirely on completed transactions, which have dried up in the recent market decline. Researcher Green Street, which bases its index on deals currently being negotiated, estimates that market values have plunged 36% since the first quarter of 2022, with some cities like Munich experiencing even sharper declines.

“If banks’ internal valuations prove unduly optimistic, or simply lag market sentiment, loan impairment charges could increase materially,” according to a report on Monday by Fitch Ratings. The ratings company expects losses from the lenders’ CRE exposure to remain high into 2025.

German property values are particularly vulnerable to higher borrowing costs because capitalization rates — or the potential return on a real estate investment — were pushed lower there than in other markets during the cheap money era. That reflected in part the fact that yields on German government bonds, a benchmark for investors, were negative at the time.

As government bond yields surged over the past two years, so did the returns real estate investors required on their deals. In Berlin, yields have risen to 4.4% from 2.4% at the start of 2022, according to data compiled by Savills. That means an office building generating an annual rent of €10 million ($10.9 million) would now be valued at just over €227 million if it traded today, a drop of almost €200 million in the period.

“We are careful and supervisors are following the developments closely, but I don’t see a reason for drama,” said Rodolphe at BaFin. “What I think isn’t sufficiently reflected in the current discussion is the fact that banks need their auditors to sign off on the appropriateness of their provisions.”

Still, differences in the way that appraisal rules are applied and interpreted means declines that would have been recognized in the UK or the US have yet to fully show up. If and when they do, that could bring swathes of commercial real estate debt closer to breaching lending terms, a move that would force lenders to provision for additional losses and also hold more capital against them.

“Banks have been more open to being patient with borrowers and delaying” the hurt in Germany, said Jackie Bowie, a managing partner at risk management firm Chatham Financial. “There is more pain to come in real estate valuations, so what does that mean for lenders and does that mean there is the potential for a crisis?”

A survey by Bayes Business School published last year showed German lenders extended senior loans worth as much as 80% of a building’s value, the highest level in Europe. While the majority of lending took place at lower thresholds, with larger buildings typically financed at 60% of their value, it’s a stark contrast to the UK where banks have been more conservative since they got scarred in the global financial crisis. 

Many of the German banks that are now staring at losses from CRE share that experience, yet it didn’t prevent them from taking risks which are now coming back to haunt them. It will be “pretty embarrassing” if banks that were bailed out in the financial crisis are shown not to have a grip on their risks, said Dinger. 

Deutsche Pfandbriefbank AG, a specialized lender that emerged from the wreckage of Hypo Real Estate, Germany’s biggest casualty of the credit crunch, saw its bonds sell off sharply in recent weeks over concerns related to its US exposure.

Now, the market is awaiting earnings from Landesbank Hessen-Thueringen, better known as Helaba, for any impairments when it reports earnings next month. Half of its real estate finance portfolio of almost €40 billion at the end of June was related to office buildings, a particular pain point. Many other lenders also have large commercial real estate books, including exposure to the US, such as Landesbank Baden-Wuerttemberg.

Officials at LBBW, PBB and Helaba, which in October raised its pretax profit guidance for 2023, declined to comment. 

The collapse of Benko’s Signa shows what can happen when the wide gap between appraised values runs into the reality of market pricing and the vital role that regulators can play when they force banks to look more closely. The ECB pushed some banks to build provisions for losses on their exposure, Bloomberg reported in August. Signa later blamed the regulator for its demise, a claim the watchdog has rejected. Since then, Switzerland’s Julius Baer Group Ltd. has written off all its Signa loans.

Another reason that provisions have remained fairly modest for now is that some lenders are agreeing workout plans with their borrowers, said Bowie at Chatham Financial. They can include offering quarterly waivers on existing breaches and short-term loan extensions, provided landlords have a clear plan for sales or building improvements, she said. 

It’s a well thumbed playbook for some German lenders. 

Back in the late 1990s while working at Lehman Bros., “we looked at the UK loan book of a German bank,” said Breslauer at Patron Capital. “Once we got the data, we saw that almost every single loan that was classified as performing had notes in the files to show it had been restructured at least three times. I suspect the same is happening today.”

--With assistance from Lucca de Paoli, Laura Benitez, Libby Cherry and Stephan Kahl.

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