Agefi Luxembourg - octobre 2024

Octobre 2024 43 AGEFI Luxembourg Immobilier CRR III –A long road, many goals T he recent amendments (1) to the Capital Requirements Regu- lation (EU) 575/2013, aka the CRR text, marked the end of a long process started by the European Commission in 2020 (2) and aimed at transposing the last batch of Basel III (3) reforms at EU-level. Notaneasytask,giventhecom- plexityofthetopic(risk-weighted assets and the prerequisite to ad- dress the worrying levels of vari- ability observed by the BCBS (4) ), coupled with the necessity to tailor thesetstandardsforthespecificcorpo- rate forms, structures and business models existing across the EuropeanUnion. Looking ahead, the official date when most amendments will come into force (5) is getting closer and closer – with 1 st Jan- uary 2025 now just around the corner. WhiletheCRRIIIchanges (6) spanacrossmultipleareas (fromcredit risk to operational risk andmarket risk), the articlewants to focus specifically on some funda- mental changes in the Standardised Approach to Credit Risk (CR-SA) –putting the exposures secured by real estate assets under themagnifying glass. Why? (I hear you say…) Because real estate, as an asset class, at a global level represents the “biggest store of wealth” according to research by Savills (7) . Yet, Luxembourg has been the subject of ESRB warnings (8) due to vulnerabilities (9) identified in its residential real estate sector, and the ECBrecentlyreleasedlessonslearned (10) onCommer- cialRealEstate(CRE)valuationfromitson-siteinspec- tions. Given that the changes introduced by CRR III are extensive, the intersection betweenprudential re- quirements, banking sector and financial stability is evermore interesting. While the link between changes in risk-weights and behaviour of credit institutions is generally not linear intheshort-term,itisnotfarfetchedtoassumethatin- creasedrisksensitivityof theCR-SAcould lead to the prioritisation of certain lending products at the detri- ment of others, which the regulators are keen to ‘dis- incentivise’ via higher capital requirements. At the same time, it will be interesting to see howreal estate funds – especially those investing in Special Purpose Vehicles(SPVs)/corporatesspecialisedinpropertyde- velopment – and the real estate markets will be im- pactedby the newwave of regulations. Real estate exposures – what’s the fuss all about? On the back of the regulators’ attempt to make CR- SAmorerisk-sensitive ,thechangestotheprudential treatment of exposures secured by real estate (11) are wide-ranging andmultifaceted, reflecting the differ- entstagesintheconstructionprocess( finishedvs.under construction ) aswell as the fundingmodels ( dependent ornotontheincomegeneratedbytheunderlyingproperty ). Buildingstrongfoundations–thefeaturesofaqual- ifying real estate property CRR III adds newrequirements for the classification of‘qualifyingrealestateproperty’ –whetherforres- idential or commercial purposes. The propertymust befinished, or thepropertyisforest/agriculturalland, or the lending is to a natural person (as opposed to corporatesandSPVs (12) )andthepropertyiseitherres- identialproperty (13) underconstructionorlandwhere Residential Real Estate (RRE) will be built. Further- more, the exposuremust be securedby a first lien, or the institution must hold the first lien as well as any lower ranking lien. Not meeting these requirements willhaveadirectimpactontheapplicablerisk-weight treatment, outlined later on. Given the crucial role played by this initial classifica- tion, credit institutionswill be forced to routinelyand consistently collect new information about the un- derlyingpropertyaswellastheborrower ,settingup adequateprocesses/policies tocapture themon inter- nal systems at the time of loan origination. Failure to do this could result inhigher capital requirements ei- therduetomisclassificationorinabilitytotakeadvan- tage of various preferential treatments available for exposures thatmeet certain criteria. The translation on real estatemarkets could be easier lending conditions (eg, attractive rates) for borrowers that intend to take out mortgages against qualifying properties, and for retail customers that are purchas- ing a property under construction (as long as it does not exceed four housingunits). IPREor not IPRE? This is the question CRR‘introduces’ (14) theconceptof IncomeProducing Real Estate (IPRE) to recognise the higher risks asso- ciated with exposures where the repayment of the loan outstanding is materially dependent on the in- come generated by the property itself (eg, rental in- come or lease payments). For institutions currently using the SA, thiswill likely require the identification ofnewinformationabouttheircounterpartiestoform partoftheircreditassessment,aswellasnewflagson internalsystemstocorrectlyclassifydifferenttypesof exposures. In practice, institutions will face the chal- lenge of putting inplace the right policies andproce- dures to decide at loan origination (and then throughout the monitoring cycle) how to correctlyclassify theexposures.Whilefor corporate/SPVcounterpartsthiscouldbe quite clear-cut (eg, both servicing and prospect of recovery in case of default depend materially on the income gen- erated by the property), for retail cus- tomersagenericruleofthumb (15) couldbe where a borrower’s ability to service a loan depends for more than 50%on income generated by the property itself. For real estate funds with investment property portfolios (ie, income generating), more attractive lending conditions may be found in jurisdictions with stable andmature real estatemarkets where the hard test is likely to be fulfilled. Exposure-to-Value(ETV)andcollateral(re)valuation Another important concept related to immovable propertyisthatof Exposure-to-Value (16) (ETV), which conditionstheapplicablerisk-weightunderthewhole loanapproach(moreonthislater).The E xposureisto be calculated on a gross basis (ie, accounting value of the asset itemrelated to the exposure secured by im- movable property + undrawn but committed amounts without considering any credit mitigation), while the V alue is basedon prudent valuation of the underlying asset. Atfirstglance,onecouldassumethattheonlychange intheratioisinthenumerator,butacloserlookatthe amendments shows that the regulators have intro- duced more conservative requirements for the val- uation of real estate collateral (17) aimed at reducing its inherent cyclical features. The main challenge faced by institutions will be the monitoring of col- lateral values , which not only need to be adjusted for potentialmaterial declines invaluebut alsomust be capped for upwards revaluations using the higher of average values (18) or the value at origina- tion.Unlike theBasel text, upwards revaluations are allowed but only where the property is subject to modifications that unequivocally increase its value (eg, renovationworks to improve energyefficiency). Andhowto forget thosepeskyEnvironmental Social and Governance (ESG) factors to be considered in monitoringmaterial decline in collateral value? This, togetherwith the other changes, could incentivise in- vestments in real estate properties for tangible im- provements, with an eye firmly on ‘greener’ features to future-proof immovable assets. Whole loan approachvs. LoanSplitting The approach to assign risk-weights has also been completelyoverhauled to take into considerationnot onlytherelativeriskinessoftheIPREvsnon-IPREex- posures, but also to better reflect the lower credit risk associatedwith lower ETV-ratio loans. Between the two approaches, Loan Splitting (LS) is the most risk-sensitive and, consequently, tends to result in more capital efficient results. Given these benefits, it comes without surprise that the LS ap- plies (without restrictions) to non-IPRE loans but can only be applied to IPRE loans if the hard test (19) is fulfilled. (See graph below) (Land)Acquisition,DevelopmentandConstruction (ADC) ThefinalkeychangeintroducedbyCRRIIIisthe new exposure class for ADC (20) , carved-out from the so- called ‘Items associated with particular high risk’ – which captured investments of speculative nature. Unlike previous capital treatment, ADC exposures can attract either a full 150% risk-weight or a prefer- ential treatment at 100%. The possibility to apply a lower risk-weight depends on the ability to fulfil cer- taincriteria (21) thathavebeenvaguelyincludedinLevel 1textbutthattheEuropeanBankingAuthority(EBA) has been tasked to define more clearly by July 2025. Draft Guidelines (22) have already been published and gone through a PublicConsultation inMay 2024. The presence of a new exposure class will force credit institutions to review current classification systems and to update policies/procedures to cor- rectly identify exposures that are eligible (or not) for the preferential treatment. On the flip side, real es- tate markets and real estate funds could be gently nudged to veer towards more conservative ap- proaches to finance their construction projects (eg, signing pre-sale contracts with substantial cash de- posits or have substantial equity at risk). Conclusions Thearticlehighlightsthekeychangesthatwillimpact credit institutions from 1 st January 2025, with regard toexposurescollateralisedbyrealestateproperty.The mainprudentialamendmentscanbesummarisedas: (1) new features for qualifying real estate assets; (2) IPRE vs non-IPRE exposures; (3) ETV and collateral (re)valuation; (4) applicable risk-weight treatments; and(5)ADCexposures.Whiletheincreasedrisk-sen- sitivityoftheCR-SArepresentsanopportunityforin- stitutions to optimise their capital requirements, this canonlybeachievedwithaconsistentandrobustap- proach up-front. Adequately adapting existing sys- tems,datacollectionpractices,policiesandprocedures will be key to harnessing latent potential and achiev- ing compliance. If on the one side optimisation could lead to lower capital requirements for credit institu- tions,ontheothertheeffectsontherealestatemarkets (both residential and commercial) and real estate funds could be felt as more stringent conditions to meet to attractmore competitive borrowing rates. LauraLEOTTA, FCCA,AdvisorySeniorManager,BankingRisk, PrudentialRegulationandCompliance Jean-PhilippeMAES, Partner,RiskManagement/ Consulting fortheFinancialSector PwC Luxembourg Fighting real estate bubbles, one CRR article at a time 1)FormallyendorsedbytheEuropeanParliamenton24April2024andby theCouncilon30May2024. 2) The review of the capital requirements framework for credit institutions waspartofthepolicyWorkProgrammeoftheEuropeanCommission. 3) The second batch of Basel reforms in Europe is also referred to as ‘Basel IV’. 4) The BCBS is the Basel Committee on Banking Supervision, an interna- tionalcommitteethatdevelopsstandards forbankingregulation.It isbased attheBank forInternationalSettlements(BIS) inBasel. 5) Some of the new provisions have already entered into force 20 days after the publication of the text (ie, on 09 July 2024). However, changes to the marketriskchapterwillnotneedtobe implementeduntil01January2026 –asdecidedbytheEuropeanCommissionon24July2024. 6) The amended text adopted by the European Parliament and Council on 31 May 2024 was published on the Official Journal of the EU on 19 June 2024. 7)“TotalValueofGlobalRealEstate:Propertyremainstheworld’sbiggest storeofwealth”–published inSeptember2023. 8) A first set of warnings was issued in 2016, when the ESRB identified medium-term vulnerabilities in the residential real estate sector. This was followed in2019bycountry-specificrecommendations.AnotherESRBre- port published in February 2022, confirmed that the previously-identified vulnerabilities remained high in the Luxembourgish residential real estate market. 9) The ESRB identified vulnerabilities mainly related to the level of house- holds’indebtednessandtheirabilitytowithstandnegativeeconomicshocks, whichcouldtranslate intofinancialstabilityrisks. 10) InAugust 2024, the ECB published its insights on CRE valuation fo- cusingspecificallyon:(1)theconceptofmarketvalue;(2)validationofcom- parable evidence; (3) documentation of special assumptions; (4) appropriateness of valuation methodologies; (5) extent of collection of ESG data on factors affecting the assets; (6) reliance on valuers’ work; (7) timely reflectionofmarkettrendsand(8)useofAVMs. 11) Under the CR-SA, real estate exposures are addressed inArticles 124- 126a, while collateral valuation requirements are addressed in Article 208 and229. 12) The distinction of whether the loan is to a natural person or not is im- portantbecause it impactstheassessmentofanexposureasADCornot. 13) CRR limits the immovable property to four residential housing units andmustbetheprimaryresidenceoftheobligor.Thelendingcannotbeused to indirectlyfinanceADCexposures. 14)While this is a new concept under the CR-SA, it already existed under the Internal Ratings Based Approach (IRBA) to Credit Risk. This further alignsthetwoapproachesanditisusefulinlightoftheOutputFloor–which effectively forces IRB institutions to calculate their Risk-Weighted Assets (RWAs)undertheSAtoo. 15)Thisruleofthumbdoesnottakeintoaccountinstanceswheretheprop- erty istheborrower’smainresidence,norwhereaborrowerhasmortgaged lessthan50%ofIPREhousingunits inacertaindevelopment. 16)UnlikethecalculationofLoan-To-Value(LTV),CRRIIIlaysoutinAr- ticle 124 (6) how to compute the gross exposure. This is in contrast to the LTV ratio, where institutions used own definitions – as reported on the EBAwebsite. In Luxembourg, the CSSF’s Technical FAQ on Regulation CSSF No. 20-08 on borrower-based measures for residential real estate creditspecifiedhowownfundsweretobecalculatedforthepurposeofLTV requirement. 17) The valuation requirements are covered in the Credit Risk Mitigation Chapter, inArticles208and229. 18)ForRRE,theaveragevalueismeasuredoverthelastsixyears.ForCRE, thetimeframe iseightyears. 19)Whiletheconceptofa‘hardtest’performedatMemberStatelevelbythe relevant CompetentAuthority is not new (CRR IIArt 124(2) – empowers CAs to review annually the appropriateness of 35%/50% risk-weights for collateralised portions of RRE and CRE loans), its repercussions have changedgivenitcannowinhibitinstitutionsfromapplyingtheLSapproach toIPRE loans. 20)AsdefinedinCRRArt4(78b),ADCareexposurestocorporatesorSPVs financing any land acquisition (for development and construction) or fi- nancingdevelopmentandconstructionofanyRREorCREproperty. 21)Tobeabletoapplythepreferentialrisk-weight,there either needstobe alegallybindingpre-sale/pre-leasecontractwithasubstantialcashdeposit subjecttoforfeitureincaseoftermination or theobligorhassubstantialeq- uityatrisk. 22)EBA/CP/2024/12 Re sid ent i al ȱ Real ȱ E s tate ȱ ( RRE ) ȱ Expo s ure s ȱ ET V ȱ bands ȱ ǂ 50% ȱ 50% Ȭ 60% ȱ 60% Ȭ 80% ȱ 80% Ȭ 90% ȱ 90% Ȭ 100% ȱ > 100% ȱ I f ȱ cr i ter i a ȱ not ȱ met ȱ N on Ȭ IPRE ȱ & ȱ q ual ifyi ng ȱ IPRE ȱ (h ar d ȱ te s t ȱ f ul fi lle d) ȱ Loan ȱ splitting ȱ (up ȱ to ȱ 55% ȱ of ȱ secured ȱ exposure) ȱ 20% ȱ RW ȱ of ȱ the ȱ counterparty ȱ Non Ȭ q ualifying ȱ real ȱ estate ȱ exposure: ȱȱ RW ȱ of ȱ the ȱ counterparty ȱ IPRE ȱ (h ar d ȱ te s t ȱ N O T ȱ f ul fi lle d) ȱ Whole ȱ loan ȱ approach ȱ 30% ȱ 35% ȱ 45% ȱ 60% ȱ 75% ȱ 105% ȱ Non Ȭ q ualifying ȱ IPRE ȱ RW: ȱ 150% ȱ Commerc i al ȱ Real ȱ E s tate ȱ ( CRE ) ȱ Expo s ure s ȱ ET V ȱ bands ȱ ǂ 60% ȱ 60% Ȭ 80% ȱ > 80% ȱ I f ȱ cr i ter i a ȱ not ȱ met ȱ N on Ȭ IPRE ȱ & ȱ q ual ifyi ng ȱ IPRE ȱ (h ar d ȱ te s t ȱ f ul fi lle d) ȱ Loan ȱ splitting ȱ (up ȱ to ȱ 55% ȱ of ȱ secured ȱ exposure) ȱ 60% ȱ RW ȱ of ȱ the ȱ counterparty ȱ Non Ȭ q ualifying ȱ real ȱ estate ȱ exposure: ȱȱ RW ȱ of ȱ the ȱ counterparty ȱ IPRE ȱ (h ar d ȱ te s t ȱ N O T ȱ f ul fi lle d) ȱ Whole ȱ loan ȱ approach ȱ 70% ȱ 90% ȱ 110% ȱ Non Ȭ q ualifying ȱ IPRE ȱ RW: ȱ 150% ȱ Table –Risk-weighttreatmentforvariousrealestateexposuresunderCRRIIIasatOctober2024Practically,theimpactoncreditinstitutionsisnotonlylinkedtothechangeincalculation butalsototherelative impactoncapitalrequirements–thoughnetnegativeorpositiveresultswilldependon individualportfoliocharacteristics Aveclesoutiende Ecofin Club Luxembourg - Table de l'immobilier Le marché résidentiel à Luxembourg - état du marché et perspective d'avenir Jacques PIROUX - Associé et agent immobilier chez Latour & Petit Jeudi 14 novembre de 11h45 à 14h15 PAF : 75 € TTC p.p. 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