Implications of Basel IV for Germany’s Real Estate Industry

While Basel IV does not actually contest its precursor framework, the new regulatory package does pack a punch. There may be time left until it takes effect in 2022. But there are changes to the lower limit for capital adequacy requirements that the real estate industry should lose no time to acknowledge.

It was by no means the end of the world. Even though the resolution in 2010 to introduce the Basel III regulatory framework for banks was accompanied by a clamorous chorus of warnings, it is now safe to say: The years since the actual, incremental introduction of Basel III started have been good years, marked by growth and stability. This is true for the global economy in general and for financial markets and the real estate market in particular.

To be sure, specific aspects have been subjected to massive changes by the elevated capital adequacy requirements and by the introduction of debt ceilings and counter-cyclical capital buffers. A number of banks have admittedly withdrawn from markets where they used to be heavily committed for decades. But ultimately it is safe to say: Banks continue to finance growth—more so than ever, in fact. For instance, the volume of loans that banks in Germany handed out to domestic companies since 2013 increased in every single year, according to the Federal Statistical Office (Destatis)—rising from 1.28 trillion euros to 1.45 trillion euros by mid-year 2018. This implies a growth by no less than 13 percent.

The robust performance appears to have won over more and more critics: The imputed long-term benefits of the Basel regulations—meaning the reduction of macro-economic costs by increasing stability and eliminating extreme risks—could outweigh the short- and medium-term drawbacks in the form of increased costs of capital. Perhaps this explains why the next step in the evolution of the Basel rules has failed to create much of a stir so far. The package of reforms commonly dubbed “Basel IV” by the public was passed by the Basel Committee on Banking Supervision under the official title “Basel III: Finalising Post-Crisis Reforms” in December 2017 and is to enter into force in 2022.

And although Basel IV leaves the principles introduced by Basel III generally uncontested, the regulatory package does pack a punch. This time, the focus is not on equity capital requirements, minimum capital ratios and liquidity indicators but on a more sophisticated assessment of the risks associated with various assets. This implies incisive changes, especially for the real estate markets.

For one thing, the risk weighting of real estate loans is to be defined primarily by the loan-to-value (LTV) ratio, meaning the amount borrowed relative to the total value of the respective property at the time of borrowing. There is principally nothing wrong with enhancing the risk sensitivity when defining capital cover requirements—as long as it remains in touch with reality and the facts on the ground. But is that actually the case here?

Looking Back: Basel III and its Ramifications for the German Real Estate Market

To properly judge the situation, it probably helps to take a look back—at Basel III. Initially, the regulatory framework was conceived as a response to the global financial crisis of 2008—the so-called subprime crisis—that had been triggered not least by non-performing mortgage loans in the United States. The idea was to make the entire global financial system more robust in its ability to cope with crises. In Europe, Basel III began to be introduced incrementally in 2014, its implementation taking the form of the Capital Adequacy Ordinance (CRR) and the Capital Requirements Directive (CRD IV). There are virtually no studies of the empirical evidence to see how Basel III has impacted the real estate market—and the question would be hard to answer anyway. Too great are the differences between the various countries in their implementation of the rules while the ramifications also strongly overlap with the effects of other macro-economic factors such as the persistently low interest rate environment.

For what it is worth, however, the BBSR Federal Institute for Research on Building, Urban Affairs and Spatial Development did an excellent job when compiling a hypothetical projection of the ramifications back in 2014. It suggests that the short-term costs are matched by long-term gains even in real estate financing and therefore in the real estate industry as a whole.

The raised capital adequacy requirements and the introduction of counter-cyclical buffers have increased the need for equity capital and thereby pushed up the overall refinancing costs for banks because equity capital is more expensive than debt. Elevated refinancing costs in turn make lending a costlier business, which is true not just for real estate financing, but applies to this as to any other business field. Then again, the changes could lower the long-term cost of capital. After all, the increased stability of the financial system could result in lower risk premiums both on equity capital and on debt capital. However, these converse effects are not the only reasons why the exact costs of Basel III are hard to quantify. Doing a qualified calculation is made even more difficult by other factors such as the extended monitoring and reporting obligations.

Nonetheless, the piecemeal introduction of the rules and regulations in the course of a transitional period ending in 2019 has arguably helped to cushion short-term ramifications and to prevent shocks. On top of that, the frequently made prediction that other players such as family offices or loan funds would to some extent fill the funding gap created by tightened bank lending practice has now become reality.

On the whole, the ramifications for the financing of residential real estate have been barely perceptible. Given the unchanged risk weighting for residential property loans at a low 35 percent up to an LTV of 80 percent, anything else would have come as a surprise. By contrast, commercial real estate is harder hit with a risk weighting of 50 percent in the case of European properties collateralised with mortgage liens. Particularly sensitive, finally, are loans in riskier real estate segments or financing arrangements outsourced via off-balance-sheet vehicles such as commercial mortgage backed securities.

Basel IV: Is Commercial Real Estate Treated Fairly?

The latest revision of the Basel framework under the headline of Basel IV seeks to maximise the degree of comparability by focusing on standard models in risk assessment. At the same time, it further tightens the existing differentiation between the various risk classes. The stated objective is to raise the capital adequacy requirements once again, and substantially so. Nevertheless, we are likely to see significant changes in equity capital in a variety of loan segments—and on either side. The effects will be felt not least in real estate financing. There is every reason to expect serious consequences, and nowhere more so than on the capital market, but possibly on the actual real estate markets as well.

Initially, the anticipated effects will be least dramatic for residential real estate loans. They are given preferential treatment even by the LTV guidance to be introduced under Basel IV. Very conservative financing arrangements with an LTV of less than 50 percent, for instance, get a risk weighting of just 20 percent. Even for an LTV between 60 to 80 percent, the risk weighting is 30 percent only. For LTVs above 100 percent, it increases drastically, all the way up to 70 percent. But there is a catch to all of the figures quoted above: They apply only to financing arrangements where the loan payments do not depend on the cash flows from the respective property. While this is likely to be the standard scenario in home financing arrangements, company-financed, let properties are a different story. The risk weighting of this latter type of financing arrangement increases significantly. In the case of an LTV between 60 and 80 percent, for instance, it equals 45 percent, meaning 50 percent higher than for financing arrangements that do not depend on the property cash flow. The situation is similar for commercial real estate—albeit on a higher level. The risk weighting of a commercial real estate loan with an LTV between 60 and 80 percent whose repayment depends on the cash flow of the actual property amounts to a whopping 90 percent under Basel IV. Does this kind of differentiation do justice to the situation on Germany’s real estate market? And can you even expect as much from a regulatory framework or global reach? The answer to either question is negative. Especially the unfavourable assessment of the risks associable with commercial real estate seems excessive and unfair when you consider the long-term stability of Germany’s commercial real estate market with its very low loss ratios. Conversely, it should be acknowledged that a global regulatory framework will work only if its complexity remains manageable. The only way to accomplish this is precisely by largely ignoring national or regional specificities—no matter how legitimate they may be.

But these hypothetical musings will help German banks that specialise in real estate financing no more than they help real estate investors and property developers, all of whom are bracing themselves for rising costs of capital. There is nevertheless no reason to panic. Just like in the case of Basel III, the introduction of Basel IV is not taking place in a vacuum. Rather, Basel IV is but one of several factors, some of which reinforce each other while others eliminate each other.

After all, property prices are now, as then, paced definitively by the interest environment—and the general level of interest rates has been subject to a downward trend for decades. At the same time, the mean loan-to-value level has substantially declined: Just 30 years ago, fully-debt financed acquisitions of commercial real estate were nothing unusual, whereas today’s standard LTV is 50 to 60 percent. While this lowers the borrowing need, on the one hand, it also merits a lower risk weighting under Basel IV, on the other hand. It should be remembered that the capital market has rapidly diversified in recent years, especially when it comes to real estate financing.

In the United States, traditionally the pioneer market, a lively rivalry has developed between traditional banks, mortgage REITs, loan funds and private equity companies. A similar trend can be observed in Germany: New forms of financing such as loan funds or crowd funding are increasingly competing with classic banks, putting pressure on margins and making loan extensions easier. Add to this that the return expectations among equity providers have gradually come down over the past years as well.

To sum up: Basel IV will probably necessitate certain adjustments in Germany’s real estate market without causing lasting damage. As with any far-reaching innovation, there are bound to be winners and losers—and if you familiarise yourself early on with the ramifications that the regulatory package will have for your business you stand a good chance to come out on top.