Why Sweden’s $41 Billion of Property Debt Is Alarming Europe

(Bloomberg) — Even in Sweden few people knew much about Castellum AB. Yet the hurried sale of 40 million shares in the property company earlier this month is now seen by some as a harbinger of things to come in the European property market.

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The seller, M2 Asset Management AB, cited falling market prices that affected its “ability to fulfill its financial commitments” for the decision. The dumping of the stake by a major shareholder, is just the latest episode in a tumultuous year in which Sweden’s property companies have seen their stock market values halve.

There is little expectation of any respite. The sector is facing $10 billion in debt repayments next year, with refinancing demands of about $41 billion by the end of 2026, according to data compiled by Bloomberg.

The funding squeeze faced by Sweden’s property companies stems from their floating-rate bonds and near-term maturities in an environment with rising interest rates. Although that makes the Nordic country’s real estate market more vulnerable than others in the region, it is being watched closely as a possible litmus test for the rest of the sector in Europe.

Some property companies could be left with no alternative but to tap the stock market to raise funds.

“Under a bad-case scenario of no thawing in credit markets, Sweden could be first in line in a series of rescue rights issues from listed property companies in Europe,” Peter Papadakos, managing director at Green Street, said. “That would have sizable implications for Europe’s listed property sector.”

The Swedish central bank and Financial Supervisory Authority have warned repeatedly that the risks stemming from commercial property debt pose a threat to the country’s financial stability. The major concern is the spillover effect for Swedish banks: property lending last year amounted to about two-thirds of total loan stock in the Nordic nation compared to less than one third in many larger euro-area economies.

Anders Kvist, a senior adviser to the director of the Swedish FSA, said the watchdog has been warning about the high levels of debt in commercial real estate companies for at least four years.

“Falling property values could trigger a domino effect,” Kvist said. “If property values fall, the available security on the loan decreases. This can lead to demands for more collateral and in turn force distressed selling.”

Commercial landlords such as Fastighets AB Balder, SBB and Castellum — which reports third-quarter results on Thursday — have spent the past decade pursuing a growth strategy in Sweden that relied on raising billions of dollars of cheap money from bond investors hungry for yield. It’s a play book that was adopted across European markets buoyed by razor-thin interest rates and booming property valuations.

Surging inflation, and the resultant aggressive tightening of monetary policy by central banks, have reversed their fortunes. The impact on Sweden’s leveraged property market, among the world’s frothiest last year, has been swift and brutal. SBB shares are down 81% in 2022. Bonds the length and breadth of the sector have tumbled to distressed levels. Balder on Wednesday had its investment-grade credit ratings placed on review for downgrade to high yield by Moody’s Investors Service.

It has become “a grim combination for many companies in a market where easy money has rewarded those with an aggressive growth agenda,” said Martin Edemalm, a bond portfolio manager at SEB Investment Management in Stockholm. “But now the market has fundamentally changed.”

Swedish property companies must roll over $40.8 billion of maturing bond debt over the next five years, a quarter of which falls due in 2023. How they navigate those repayments is seen as critical for the wider European sector.

“European real estate firms in general tend to have lower leverage and longer debt maturity profiles than their Swedish peers,” said Edemalm, whose firm manages about 300 billion kronor ($26.5 billion) worth of bonds. “But rising interest rates are a clear negative for the asset class so it is reasonable to assume that yield requirements will increase for European real estate putting pressure on valuations.”

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With bond yields — and hence borrowing costs — trading at unaffordably high levels much of the debt financing route has become too expensive for some companies. Last quarter, property bond sales shrank to 6.3 billion kronor, the lowest since the final three months of 2018. That crunch is leaving issuers scrambling to secure bank loans as their balance sheets creak under the weight of high leverage and falling property valuations.

Jens Andersson, Castellum’s chief financial officer, said the company is exploring other funding markets in addition to traditional mortgage loans from Nordic banks. He cited the example of US private placements because of their long duration and competitive pricing. But even that sector has its hurdles to overcome after recent gilt market turmoil in the UK.

An alternative option to help ease the funding squeeze has been to sell assets. SBB offloaded properties totaling 6.7 billion kronor during the second quarter and has more recently announced further sales of at least 10.5 billion kronor. In July, Standard & Poor’s cautioned there was “a one-in-three chance” it could lower its ratings on the landlord to non-investment grade.

These sales have drawn attention to a further concern among investors: Sweden’s unusually high levels of cross ownership, which have previously sparked warnings from rating agencies over governance risks and potential conflicts of interest. M2 Asset Management sold its stake in Castellum to another landlord, Akelius Residential Property AB.

Property mogul Rutger Arnhult raised eyebrows when he was appointed chief executive officer of Castellum after first being elected its chairman. Arnhult also controls M2 and is the largest owner in Corem Property Group, which last year joined another of his holdings, Klovern AB, in a $1.7 billion merger. Castellum in turn owns a third of Norwegian landlord Entra ASA, in which Balder is also a shareholder.

In a report on the country’s financial system in May, the FSA said the growth in debt in the real estate sector means that it continues to be “a significant vulnerability for financial stability.” The watchdog added that it is closely following the debt of commercial property companies because they have “often played an important role in financial crises.”

Maria Gillholm, a real estate analyst at Moody’s, says the complex ownership webs among Swedish property firms “further limits their access to capital, because companies typically focus on protecting their own liquidity in a downturn.”

“Entra, where Castellum and Balder together hold a majority stake, is a good example” she said. “In a downturn when you have to take care of your own liquidity and maybe sell assets, it could be tougher to get everyone to support an equity injection.”

The silver lining for money managers such as Edemalm is that the sell off has been so severe that there are now bargains to be picked up once you drill down into the sector’s different sub-segments, such as higher yielding properties in the office, industrial or logistics spaces.

The portfolio manager points to euro hybrid debt sold by Balder, Castellum and Heimstaden Bostad AB as examples of top picks.

These segments are “less sensitive to increasing interest costs and will benefit from CPI-linked contracts,” the portfolio manager said. “But the most important things right now are solid balance sheets and strong supportive owners.”