European banks are over-valuing commercial property, ECB report suggests

An analysis by the European Central Bank (ECB) has raised concerns that several of the Euro zone’s leading banks may be inflating the value of commercial property, potentially obscuring the true state of their loan portfolios in a sector that is facing significant challenges. The analysis suggests that some banks are failing to properly account for the steep downturn in the commercial property market, which has been severely impacted by higher borrowing costs and weakened demand as businesses adjust to the post-pandemic economic landscape.

Commercial property prices have experienced a sharp decline, with the ECB estimating a nearly 10% drop in value last year alone. This decline has been driven by rising interest rates and reduced demand in key segments of the market, creating a challenging environment for borrowers who are increasingly struggling to service their debts. The ECB’s inspection teams identified various issues in how banks are commissioning and conducting property valuations, which could result in the overvaluation of assets used as collateral for loans.

One of the key findings of the inspection was that some banks are relying on outdated transaction data, using figures from 2021 or earlier to justify current valuations. This practice overlooks the significant changes in the market, including increased inflation and higher ECB interest rates, which have fundamentally altered the economic conditions since those earlier transactions. The ECB criticized these banks for failing to adjust valuations to reflect the current downturn, warning that such practices could lead to an overestimation of collateral value and an underestimation of the risks associated with their loan portfolios.

The ECB also took issue with the methodology some banks use to determine market value. According to the inspection, some banks are interpreting market value as the price they hope to achieve in the future when they eventually sell the property, rather than basing valuations on the economic conditions at the time of assessment. The ECB emphasized that valuations must reflect the realities of the market at the reference date, rather than speculative future conditions that may or may not materialize.

Another problem identified by the inspectors was the practice of averaging multiple valuations without critically assessing the methodology behind each one. The ECB argued that when there are discrepancies between valuations, banks should investigate the reasons for these differences rather than simply averaging the figures. Additionally, some banks were found to be underestimating the impact of higher construction costs on new developments and accepting overly optimistic valuations based on the highest and best use of the property, rather than more conservative and realistic assumptions.

The ECB’s findings highlight the need for greater scrutiny and more accurate valuation practices among euro zone banks, particularly in a commercial property market that continues to face significant headwinds. The central bank’s warnings underscore the potential risks that inflated valuations could pose to financial stability if not properly addressed.