A German bank is bracing for a wave of defaults on its commercial real estate loans, echoing concerns from the U.S. about a growing CRE debt trap.

Deutsche Pfandbriefbank, also known as PBB, has set aside €215 million ($231.7 million) to cover bad CRE loans following the biggest drop in commercial property values since the 2008 financial crisis.

The bank said its growing expenses are due to “persistent weakness of the real estate markets.” For the next six months, PBB will be drawing from its “liquidity cushion” of reserve assets as it monitors its mortgage portfolio.

PBB is by no means the biggest German holder of CRE loans—Deutsche Bank, LBBW, Bayerische Landesbank, Aareal, and DZ Bank all have bigger mortgage portfolios. Deutsche Bank has the largest CRE portfolio at more than €50 billion ($53.8 billion).

Germany’s commercial property prices plunged by 10.2% in 2023, mirroring declines across the euro area, according to the VDP banking association.

In addition to falling prices, the impacts of rising vacancy rates and higher building costs have squeezed the market, exposing banks to major losses as building owners struggle to make payments or refuse to sell at reduced prices.

Overall, European banks are sitting on $1.5 trillion in CRE loans. Germany is the biggest domino, accounting for roughly one-fifth of the loans.

“Valuations are still too high. Everybody knows it. But at a certain point of time, people need to drop their pants,” Alexandre Grellier, founder of property dealmaker Drooms, told Reuters.

Warnings of a 2008-like crash aren’t limited to Germany. In the United States, nearly 1 billion square feet of empty office space is lining major cities, creating what experts call a “liquidity gridlock.”

CRE trouble on American shores

Like in Germany, commercial property values in the U.S. nosedived 11% after the Fed began raising interest rates, according to the IMF.

“One of the steepest price declines in at least a half-century heightens risks to investors and lenders,” wrote IMF researchers Andrea Deghi, Fabio Natalucci, and Mahvash Qureshi.

Losses on commercial real estate are at the center of a burning hole in banks’ balance sheets.

According to the National Bureau of Economic Research (NBER), banks have seen the cumulative value of their long-term assets fall by $2.2 trillion since the Fed began raising rates. This figure includes losses on government bonds, corporate loans, and mortgages.

U.S. commercial property is being dragged down by a nearly 20% vacancy rate for office space—a remnant of the semi-permanent shift to remote work during the pandemic.

As Creditnews reported, there’s growing pressure to convert empty office space into apartment buildings—a highly complicated and expensive process.

With more than $2.2 trillion in commercial mortgages scheduled to mature over the next four years, banks will struggle to get building owners to refinance at higher interest rates.

“The market is strained for liquidity; it's an absolute gridlock. Even with a massive drop in valuations in vacant buildings, there is no guarantee you will generate returns to justify the investment,” said Razmig Boladian, co-managing partner at Rubicon Point Partners, a real estate operator.

If things really go south and building owners begin to default, banks could be looking at between $80 billion and $160 billion in losses, according to NBER. Those losses are based on default rates of 10% or 20%, which are consistent with the 2008 financial crisis.

Unfortunately, it’s smaller and mid-sized banks that are most exposed.

Losses are no longer hypothetical

The NBER study assumed hypothetical default rates, but there’s nothing hypothetical about recent losses reported by New York Community Bancorp, a regional bank with fewer than 400 branches.

New York Community Bancorp posted a surprise $252 million loss in its fourth quarter, largely due to bad office loans. Its stock nosedived by 60% over eight days as Moody’s downgraded its credit grade.

Even foreign banks with exposure to U.S. commercial real estate are showing signs of stress. Japan’s Aozora Bank partly blamed its investments in U.S. office space for its $190 million loss in 2023.

Although larger banks aren’t immune to losses in CRE, smaller banks have 4.4 times more exposure, according to JPMorgan.

As a result, banks are quietly setting aside more money to cover credit losses and charge-offs tied to their underperforming CRE loans.

“This is going to go on for at least a year, where [non-performing loans] continue to rise, followed by charge-offs—it's going to be really ugly,” according to Rebel Cole, a finance professor at Florida Atlantic University.