Commercial property is weak link in euro zone finance, ECB says

FRANKFURT, May 16 (Reuters) - Commercial property has become the weak link of the euro zone's financial system, with losses there threatening to hurt banks, insurers and funds, a European Central Bank report showed on Thursday.

Commercial real estate (CRE) companies have been hit by a triple whammy of higher borrowing costs, falling demand for office space in the post-pandemic age, and more expensive building materials.

Their problems are now starting to spread to their backers in the form of rising default rates on loans and looming losses on investments, the ECB said in its twice yearly Financial Stability Review (FSR).

The central bank for the 20 countries that share the euro said commercial property prices were down 8.7% year-on-year at the end of 2023 and may have further to fall.

"Prices could decline further, given structurally lower demand for some CRE assets post-pandemic," the ECB said. "The outlook for the office market is particularly bleak."

The sector was a sour note in an otherwise more positive FSR, in which the ECB noted the risk of a recession had declined despite lingering geopolitical risks.

The central bank said around half of the euro zone's large real estate companies were making losses and their ability to make interest payments from earnings had declined substantially.

While commercial property only accounted for a small portion of all loans, the ECB said "a handful of banks" had already suffered "a significant deterioration in their CRE portfolios", particularly in the United States.

Falling property valuations were likely to force banks to raise provisions and "may, in some cases, lead to erosion of capital", the ECB added.

In a similar vein, the ECB noted the reported net asset value of Real Estate Investment Funds (REIF) had remained stable despite the significant drop in property prices, suggesting losses had yet to be booked.

"Such losses might trigger redemption requests for REIFs, putting stress on their cash buffers," the ECB said.

Insurers, in turn, may face losses on their investments in REIFs, which they had boosted during the previous era of low interest rates and booming property markets.

"Consequently, interconnectedness in commercial real estate exposures across the financial system warrants continued monitoring," the ECB said. (Reporting by Francesco Canepa Editing by Mark Potter)