Worries about US commercial property are making a German bank nervous. What had previously promised high profits is becoming a massive problem for Deutsche Pfandbriefbank (pbb). The mid-sized bank based near Munich specializes in commercial real estate loans in Europe, but is also heavily invested in America.

The vacancy rates for offices and business premises there are higher than they have been for years. It is partly a knock-on effect of the COVID-19 pandemic and the new norm of working from home. More broadly, tighter lending, higher interest rates and inflation are making construction and real estate less attractive.

Overall, pbb is sitting on customer loans of just over €49 billion ($52.9 billion). Of that, around 44% of its real estate financing is connected to commercial real estate in Germany. Yet around €5.4 billion, or 15%, is tied to commercial real estate in the US. A market "where uncertainty surrounding commercial real estate valuations is particularly high," according to a recent report by S&P, a credit rating agency.

To make matters worse, as of last September, 12.8% of the US loans are considered problematic, "a huge difference compared to the estimated ratio of 0.3% for the German risk exposure," said Vladislav Krivenkov from Hamburg-based nordIX, a specialist for bonds and derivatives that advises institutional investors.

Taking stock as the stocks tumble

Many other German banks have real estate investments, but these businesses are generally more diversified. On February 14, S&P downgraded both its long- and short-term outlook for pbb due to its strong exposure to commercial real estate, including offices, retail, logistics and hotels. For the rating agency, it is the bank's "narrow mix of business lines" that is cause for alarm.

Investors' reaction was swift and the bank's share price fell to an all-time low. Since the start of January, the stock is down 40%.

Perhaps in anticipation of this, the bank previously issued two bulletins to try and reassure investors about its general financial health. It announced that despite the situation "pbb remains profitable thanks to its financial strength — even in the greatest real estate crisis since the financial crisis." It also vowed to have enough cash to deal with a downturn in the US.

The situation for commercial real estate in the US, especially for office properties, is challenging, says Jens Tolckmitt, chief executive of the Association of German Pfandbrief Banks (vdp). But the entire real estate industry cannot be judged together. "Individual property types and locations are affected completely differently," he told DW.

Still, the sector seems to be in distress, and "investors are nervous," said Krivenkov, a portfolio manager who runs one of nordIX's funds.

But he is hopeful that the current situation is "more an asset repricing than a bubble burst, as seen during the subprime crisis in the US starting from 2007." The fact that a relatively unknown mid-sized German bank is struggling shouldn't be taken as a sign of a wider financial crisis. Plus, the market could soon stabilize, possibly through interest rate cuts, which many expect are coming.

Finding security in 'Pfandbriefe'

That would be good news for pbb, since real estate finance accounts for most of its earnings. In 2023, pre-tax profits were €90 million, according to preliminary results. A big decline compared with €213 million the previous year and €242 million in 2021. Still, S&P sees the bank remaining "moderately profitable" this year.

Despite the challenges ahead, Tolckmitt doesn't think this is the beginning of a new systemic financial crisis either. "Since the experiences of 2008, [German] banks have been regulated more strictly and are better capitalized, which means they have significantly more equity and are more resilient."

Moreover, pbb specializes in the German Pfandbrief, a very specific "covered bond," to fund loans. "The Pfandbrief is very safe for investors," said Tolckmitt, pointing out that Pfandbrief-based financing is very conservative when determining loan-to-value rates and typically only finances 40-50% of the market value.

Is real estate an Achilles heel?

Recently there have been several real estate crises from residential property woes in China to the downfall of luxury property developer Signa in Germany and Austria.

What is bothering pbb investors is something else — workers staying at home. Empty office buildings, businesses reducing their floorplans and shops closing are all reasons to be on edge. S&P points out that around 65% of the bank's real estate finance portfolio is in the office, retail and hotel segments.

Though COVID-related vacant buildings are not new, long leases led to a time delay. Owners that hoped to sit it out are now dealing with a new reality. Empty buildings pull down values and many properties are not worth what they once were. When owners go bankrupt, lenders are left holding the bag.

"Despite the many differences between Credit Suisse and Silicon Valley Bank, their intersection was their insolvency due to a bank run, which is one of the most feared risks by bank CEOs," Krivenkov told DW.

This scenario seems far off. But whatever happens now will show the results of increased regulation, a different perception of risk, and "how resilient" German banks really are, he concluded.

Edited by: Ashutosh Pandey