DEFCON 3

• UK banks' stage 3 ratios remain under 2%
• Around $100bn of commercial property distress in the USA, of which 50% are offices?
• In Europe, over 50% of properties placed into distress since 2023 are in Germany
• Of the 13 NPL’s on one German lender book in 2024, 10 were US offices and 3 in Germany ?
• As implementation of regulation (Basel IV) impacts Banks, alternative lenders provide fillip – but by shifting risks?

Historical insights: South Korean banking crisis

In the wake of the 1997 Asian Financial Crisis, South Korean banks were facing a severe crisis. The economy plunged into recession and a large number of loans became non-performing. By 1998, the NPL ratio in South Korea reached as high as 10% of total loans in some banks. In response, the South Korean government, supported by the International Monetary Fund (IMF), introduced a series of reforms to restructure the banking industry. Despite the immediate financial distress, these efforts enabled South Korea's banking sector to recover much faster than many experts had predicted and by the early 2000s the country had restored its economic health, the banks had stabilized, and the economy started growing again.?

Broader economic outlook

There are amber warning lights within the broader economy, but real estate credit has remained broadly resilient, with distress localised (mainly in the USA and Germany) and cauterized (to the office sector). With $400 billion of accumulated dry powder to take advantage of the opportunity according to Preqin, many will unlikely be able to take advantage of these opportunities, as they've either missed it or they are too well bid.

Bank resilience amidst distress

Take UK bank’s for instance. Profitability will remain robust into 2025. Return on risk-weighted assets held at around 2% in 2024, and return on equity was steady at 10%, supported by strong net interest income and recovering loan growth. Capital levels are solid, with an average CET1 ratio of 14.1% and buffers ranging between 1.5%–4%. Mortgage arrears are rising, but remain very low at just 1.1% of homeowners and 0.7% of buy-to-let loans. Insolvencies, particularly in construction, wholesale and retail, are high – but this reflects a growing corporate base. Banks’ stage 3 ratios remain under 2% for most, with only mild increases reported in 2024, driven by specific exposures such as US consumer at Barclays, China CRE at HSBC, and isolated UK cases at Santander.

What is being reflected in the CMBS market?

Specifically in the real estate capital markets space, best illustrated by CMBS, issuance volumes more than doubled in 2024, with €2.3bn priced across five deals: three industrial and logistics, one office and one data centre. The market expects €5bn of issuance in 2025. According to Scope Ratings, refinancing stress remains for existing securitised loans, with 60% by number facing high or very high refinancing risk due to scarcer and costlier debt and lower valuations. On the positive side, Scope reported no defaults at maturity, and the three loans that defaulted in 2024 were either corrected or are close to resolution. Indeed, most loans have shown improvement in one or both of debt yield or loan-to-value compared to December 2023, with 47% of loans improving on both metrics, and another 32% improved on one. Of the 10 loans (19%) with both metrics deteriorating, six are secured by office and three by retail. The retail sector is enjoying a renaissance, with 83% of loans improving. Office persists with its woes with only one loan, Viridis (backed by Aldgate Tower), which saw meaningful improvement, thanks to new equity and tenant expansion.?

European corporate distress stabilising

Corporate distress across Europe is above the long-run average but showing signs of stabilisation. According to the Weil European Distress Index, an “uneven recovery” is forecast for 2025, driven by structural vulnerabilities, geopolitical tensions and industry-specific headwinds. Real estate remains under pressure, “which is now the second most distressed sector, due to limited refinancing and compressed investment metrics”.?

US market distress specifics

According to MSCI, in the US, commercial property distress rose to $102.6bn by Q3 2024, with new distress inflows outpacing workouts between property owners and lenders by $4.3bn. Offices constituted nearly half of the market distress, with $50.2bn, followed by retail and multifamily.

German development and lender distress

In Europe, over 50% of properties placed into distress since the start of 2023 are located in Germany, where rapid repricing and higher average LTVs than were on offer in other European countries. However, this has not translated into widespread distress elsewhere, according to Bayes Business School. PGIM estimates €30bn of German development assets, including Signa, are now in insolvency. Adding in fund liquidations, it’s clear the development sector is undergoing a correction, though this remains confined to a specific slice of the market. PGIM notes that the “opportunity is there,” and the real question is whether core capital will return to the fray.

The geographical and sectoral focus on real estate NPL’s is meaningfully illustrated with the example of German lender PBB. Its real estate NPL's rose from €1.5 to €1.9bn, primarily due to 13 new NPL’s, 10 of which involved US office’s and three German development loans. PBB’s share price hit record lows in 2024 down c20%, reflecting its US and German exposure. In response to rising loan-to-value ratios, it has been selling assets and reportedly signed an MoU with Starwood Capital in October 2024 to establish a strategic partnership in CRE lending. Notably, margins on PBB’s book rose from 205 to 240 bps and its share price this year has recovered significantly.

Italian banks' asset quality

According to Fitch ratings, Italian NPL collections dropped 62% m/m in January 2025, led by weaker discounted payoffs (DPOs) and note sales. But bank asset quality remains strong. Fitch forecasts impaired loan ratios below 4% for major banks in 2024 and 2025. The median ratio decreased to 2.8% at end-2023 (from 3.2% at end-2022), not far above the level for large European banks (about 2.5%). Fitch estimate that Italian banks’ CRE exposure is generally lower than many large European banks relative to common equity CET1 capital. They estimate they held approximately €70bn of CRE exposure at end-2023 (excluding exposure to the construction sector), equivalent to about 60% of their CET1 capital.

Elevated borrowing costs in Europe

European real estate issuers have faced a sharp rise in borrowing costs since 2021, with rates now two to three times higher than before. This has priced some companies out of the capital markets, pushing them towards secured lending, often requiring deleveraging first. Although swap rates and credit margins have fallen since their 2023 peak, making all-in financing cheaper, weaker borrowers remain under pressure. Investment-grade issuers have benefited from improved market access, with bond funding costs falling from over 5% to around 3–4% by early 2025, thanks to lower policy rates and narrowing spreads.?

Bond issuance has remained strong in early 2025, with volumes comparable to last year’s and well above 2023 levels, reflecting renewed investor confidence and easing refinancing risk. However, this recovery is uneven. Sub-investment-grade corporates still face high borrowing costs, starting at 6.5%, significantly above typical property yields, leaving them largely excluded from unsecured bond markets.

Growth of alternative lending

Banks still account for 85% of CRE debt, but their share is falling. Surveys confirm debt funds’ modest share of annual lending so far. But their share has been increasing. In the UK, Bayes’ survey shows debt funds’ share increased from 12% in 2019 to 20% in 2023. Also, in France IEIF reports an increase from 7% in 2019 to 10% in 2022. Net CRE lending by debt funds overtook banks in both 2021 and 2023. As banks face regulatory pressure to reduce their CRE exposures further, debt funds are expected to increase their share. Basel IV took effect in January 2025, raising capital requirements for CRE loans. Swedish, German and Danish banks will be most affected. EU banks can no longer reduce RWAs below 72.5% of standardised levels, increasing Tier 1 capital needs by 24.4% on average. Holding real estate loans will now require higher capital buffers, making this more expensive for EU banks. This basically encourages alternative lending models. This shift in capital costs is accelerating the rise of private credit — not just as an alternative, but as a structurally integrated component of post-Basel real estate finance.

Recent strategic partnerships between banks and asset managers highlight a shift in real estate financing, with institutions seeking to regain market share through capital-efficient models (Apollo / Athene, KKR / Global Atlantic, Blackstone / Resolution Life, AIG etc). While these arrangements fill the void from retreating banks and offer speed, scale, and efficiency, they also raise a critical question: are they fully aligned with the intent of Basel IV, or are they sophisticated regulatory workarounds enabling banks to shift risk off balance sheet while maintaining influence over credit markets?

These developments matter because they signal a deeper structural shift in how real estate and corporate credit are financed. By tapping into alternative capital sources, such partnerships provide diversified funding channels for mid-market and larger enterprises, sustaining investment as traditional bank lending tightens. Banks, rather than competing with private credit, are increasingly collaborating with it — reshaping their role from balance sheet lenders to capital-light originators and facilitators.?While this enhances market depth and flexibility, this evolution complicates monetary policy transmission, as more credit flows through loosely regulated channels beyond the direct reach of central banks. Moreover, the separation of loan origination from capital provision introduces agency risks: with originators incentivised by deal flow, there’s a danger that credit quality may be compromised in pursuit of volume, raising concerns about long-term systemic resilience.

Summary: localised distress amidst broader resilience

Across banks, capital markets and private credit, distress is a story of pockets rather than widespread contagion. From German developers and US offices to extended CMBS loans, risk is concentrated and, in many cases, actively managed. Improved funding conditions and strong capital cushions provide a buffer, and where refinancing fails, new capital is waiting to step in. In the context of U.S. military defense readiness, DEFCON stands for "Defense Condition" and is a military system for ranking defense readiness. We are perhaps at level 3 at best, signifying needing to be prepared, but expecting little action imminently.?