(Bloomberg) -- The euro region’s top financial regulator has warned of widespread issues in how banks value the collateral underpinning tens of billions of commercial real estate loans, highlighting the potential for lenders to underestimate their vulnerability to a property crash.
The European Central Bank has been undertaking on site inspections of banks’ processes since 2018, including asking property valuers for details of how they do their work, and has found “a range of problems in how banks commission or carry out valuations.”
Those include banks setting ‘market value’ at the level they believe they can eventually achieve from selling an asset, rather than the value they would recover now, a practice that is particularly misleading during market downturns when banks’ valuations price in a subsequent rebound. The metric is “frequently misunderstood or wrongly applied,” the supervisor found.
Investors have been concerned about lenders’ exposure to commercial real estate, and especially the office sector, after demand collapsed during the pandemic. Landlords and banks have been hoping that interest rate cuts by the central bank will boost demand for the assets and allow the market to bottom out. That’s premature, the ECB warned on Wednesday, because of the problems it’s seen with valuations.
Banks were also criticized for “wrongly” applying accounting conventions “to inflate market values” by setting the metric as the best price that could possibly be achieved for a development project, as well as using “outdated and inappropriate market data” and “ignoring current market sentiment and expectations of market participants.”
“During the second half of 2022 and throughout 2023, the inspection teams found cases where banks or their valuers were relying on transactional evidence from 2021 or earlier,” the ECB wrote.
The supervisors were unpersuaded by the banks’ defense that, even though the economy was worsening and inflation and interest rates were rising, “without more recent transactional evidence, there was no evidence that the market value had fallen”.
From next year, appraisals will have to exclude expectations of price increases.
Other issues uncovered by the ECB include not properly interrogating valuers’ work, citing one case where a property was classed as vacant when it had long-term squatters.
“Supervisors across the globe are facing similar issues in this area, and ECB banking supervision actively shares the experience gained over several years of inspections,” the ECB said of its overall findings. “The CRE on-site inspections campaign team will enter into further discussions with external auditors and CRE standard-setting bodies.”
Europe’s banks have about €1.4 trillion of commercial real estate loans, according to the European Banking Authority, with almost 18% classified as stage 2, meaning there’s a significant increase in credit risk.
“The ongoing market downturn for commercial real estate warrants particular attention, as it could have knock-on effects on the asset quality of some banks,” the ECB said in the report. “With higher interest rates and lower demand weighing on key segments, borrowers are more likely to face debt servicing challenges. Prudent collateral valuation is therefore highly important.”
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