German banks are taking proactive measures to reduce their exposure to the struggling US commercial real estate (CRE) market, particularly in the office sector. Faced with concerns about potential losses, these lenders are selling off billions in loans linked to American office properties, seeking to mitigate the fallout from the deteriorating market conditions.

Navigating the Turbulent US CRE Landscape

Shedding Risky Assets

Deutsche Bank AG is nearing the sale of approximately $1 billion in loans tied to US CRE, while Deutsche Pfandbriefbank AG is scaling back its office and American loan portfolios after setting aside hundreds of millions of euros as a buffer against potential property losses. Landesbank Hessen-Thueringen Girozentrale is also exploring options, including the sale of its stake in a portfolio of loans linked to US offices.Aareal Bank AG, another major lender to the US CRE market, has already reduced its soured office loans by around €500 million ($543 million) in an effort to contain the fallout from the weakening property markets. These strategic moves by German banks underscore their determination to proactively manage their exposure and minimize the impact of the ongoing CRE downturn.

Pressure from the ECB

The sales come as market participants anticipate the European Central Bank (ECB) will push German banks to recognize higher losses on their American assets. According to Stijn Van Nieuwerburgh, a professor at Columbia University Graduate School of Business, values on average have fallen by more than 75% from the peak for all but the best US offices.This stark decline in property values has resulted in "unrealized losses across most vintage periods for office, even for loans originated well before the pandemic," as noted by MSCI Real Assets analysts Fritz Louw and Jim Costello in an October report. The report also highlighted the forecast that about one quarter of the country's office space will be vacant by 2026, further exacerbating the challenges faced by CRE lenders.

Stabilizing Signals

Despite the gloomy outlook, there are some signs of optimism. Deutsche Bank claims that the pricing of the loan portfolio it is selling is evidence that the CRE market is stabilizing. Additionally, declining interest rates have boosted hopes that the worst of the decline may be over.However, the market turmoil earlier this year, sparked by New York Community Bancorp's (now Flagstar Financial Inc.) decision to slash dividends to build a larger loss buffer, serves as a cautionary tale. Credit provisions at Flagstar Financial rose 237% to $947 million in the first nine months of the year compared to the same period in 2023, underscoring the ongoing challenges faced by CRE lenders.

Kicking the Can Down the Road

In response to the downturn, US banks have been accused of "extending the maturity of their distressed CRE mortgages coming due and pretending that such credit provision was not as risky to avoid further depleting their capital," as warned by New York Federal Reserve staff in an October research paper. This "wall of debt" represents a significant financial stability risk, according to the researchers.

Higher Exposure for German Lenders

While the US-focused study did not specifically target German banks, these lenders have higher CRE exposures than most of their European peers. The fact that German banks typically only value their domestic assets annually, compared to as often as quarterly in the US, has led to more volatility in America and is one of the reasons why they are now offloading these assets.As German banks navigate the turbulent US CRE landscape, their strategic decisions to sell off risky loans and reduce exposure reflect a proactive approach to managing the potential fallout from the ongoing market challenges. By shedding these assets, they aim to mitigate the impact of the CRE downturn and position themselves for a more stable future.