‘ANNEX V

GUIDANCE ON DEFINITIONS AND INDICATORS

This Annex provides guidance on specific issues related to the definition of indicators and in particular on Annex III. Its purpose is not to provide detailed technical instructions for completing the Templates of Annex III covering all possible cases. Moreover, the guidance should be interpreted as covering target definitions and target methods, and in some cases divergences might be justified to accommodate for the specificities of markets or market segments.

1. Definitions of commercial real estate

There is currently no Union-wide definition of CRE that is sufficiently precise for macroprudential purposes.

(a) Regulation (EU) No 575/2013 defines RRE in Article 4(1)(75) but does not provide a precise definition of CRE, other than describing it as ‘offices or other commercial premises’ in Article 126. This Regulation also requires that the property value should not depend on the credit quality of the borrower or the performance of the underlying project as regards CRE.

(b) EBA provided a useful additional criterion: the dominant purposes of the property ‘should be linked to an economic activity’ (1). While useful, this criterion is still not precise enough for macroprudential purposes.

(c) Regulation (EU) 2016/867 of the European Central Bank (ECB/2016/13) (2) is another possible source for the definition of CRE. While the premise on which this Recommendation was originally issued justified the adoption of more detailed definitions for financial stability purposes, recent developments in statistics have highlighted the need to align more closely the definition of CRE with that in Regulation (EU) 2016/867, in order to facilitate the monitoring activities and financial analyses of national macroprudential authorities and to allow for complete comparability between countries.

(d) The G20 Data Gaps initiative (3) is a set of 20 recommendations on the enhancement of economics and financial statistics that was launched in order to improve the availability and comparability of economic and financial data following the financial crisis of 2007-08. Recommendations II.17 and II.18 of the Second Phase of the G20 Data Gaps Initiative (DGI-2) (4) highlight the requirement to improve the availability of both residential and commercial real estate statistics. Following up on this initiative, in 2017, the Commission (Eurostat) published a report on ‘Commercial property price indicators: sources, methods and issues’ (5), which provides input on the source data and methodologies in relation to commercial property price indices, with the aim of better informing compilers and users of alternative data sources, measurement methods, and the issues at stake.

(e) The Basel Committee on Banking Supervision's consultation document on revisions to the standardised approach for credit risk (6) also defines CRE as the opposite of RRE. An RRE exposure is defined as an exposure secured by an immovable property that has the nature of a dwelling and satisfies all applicable laws and regulations enabling the property to be occupied for housing purposes, i.e. residential property. A CRE exposure is then defined as an exposure secured by any immovable property that is not a residential property.

In view of the limitations of the definitions set out above, this Recommendation provides a working definition of CRE specifically for macroprudential purposes. It defines CRE as any income-producing real estate, either existing or under development, including rental housing; or real estate used by the owners of the property for conducting their business, purpose or activity, either existing or under construction; that is not classified as RRE; and includes social housing.

Whether property under development should be considered as CRE can be debated. In this respect national practices vary. However, the experience of a number of Member States during the recent financial crisis has demonstrated how important it is for financial stability purposes to monitor investments in, and the financing of, this economic activity.

Income-producing real estate is defined as all immovable properties with income generated by their rents or profits from their sale. Therefore, buy-to-let housing and rental housing are both sub-categories of income-producing real estate.

Buy-to-let housing refers to any real estate directly owned by natural persons, with the primary aim of being let to tenants. Buy-to-let housing is a border area between RRE and CRE. However, since this activity is typically undertaken by part-time, non-professional landlords with a small property portfolio this can be interpreted for financial stability purposes as belonging more to the RRE sector rather than to the CRE sector. For this reason buy-to-let housing is classified as RRE and is therefore automatically excluded from the definition of CRE, even though it is still considered to be income-producing real estate. Nevertheless, because of its distinct risk characteristics, national macroprudential authorities are recommended to monitor developments in this sub-market under a separate breakdown, should this activity represent a significant source of risks or a significant share of the stock or flows of total RRE lending. For this reason, a breakdown of RRE loans has also been included to distinguish between buy-to-let loans and owner occupied loans. Buy-to-let housing which is under construction is also deemed to be RRE. Similarly, dwellings which are being constructed with the aim of being used for dwelling purposes by the owners are also deemed to be RRE property.

Rental housing refers to real estate which is owned by legal entities (such as professional investors) with the aim of being let to tenants. Such properties are also deemed to be income-producing real estate and as such are classified as CRE. In addition, rental housing which is under construction is also classified as CRE, and in particular as income-producing real estate under development. Separate monitoring of the financing of rental housing may also be relevant for financial stability purposes. For this reason, separate breakdowns have been included for these types of loans.

Income-producing real estate other than buy-to-let housing and rental housing is also included in the definition of CRE, whether existing or under construction. Examples of such other types of income-producing real estate include rented office buildings and rented business premises. When under construction, such types of income-producing real estate are considered to be income-producing real estate under development, which is classified as CRE.

Real estate used by the owners of the property for conducting their business, purpose or activity includes business premises, as well as real estate of a more sui generis nature, such as churches, universities, museums, etc. Whether real estate used by the owners of the property for conducting their business, purpose or activity should be classified as CRE or as another type of real estate can be debated. In this respect, national practices vary, since the risks associated with such real estate may, in some Member States, be considered to be different from the risks associated with CRE. Nevertheless, while acknowledging that the risks may vary across Member States, it is also important to monitor such risks for financial stability purposes. For this reason, real estate used by the owners of the property for conducting their business, purpose or activity has been included in the definition of CRE. In addition, to cater for the specificities of the financing of the different real estate markets across Member States, separate breakdowns are also included in order to monitor risks connected to these types of financing separately. Real estate used by the owners of the property for conducting their business, purpose or activity should also be considered as CRE both during the construction phase and upon completion.

Social housing is a complex segment of the real estate market, as it may take different forms across and within Member States. Given that social housing is not usually built, acquired or renovated by natural persons, it is not classified as RRE, but as CRE. However, in some countries, in view of financial stability considerations, it is important to monitor the risks stemming from this type of property under a separate breakdown. For this reason, separate breakdowns have been added for these types of loans. In addition, social housing which is owned directly by the State is deemed to be owned for the purpose of conducting the government's purpose and is therefore also classified as CRE. Social housing which is still under construction is also classified as CRE, as it is considered as income-producing real estate under development.

Any other properties under construction should be considered as either RRE or CRE in accordance with the general definitions in points (4) and (38), respectively, of section 2(1)(1).

2. Data sources on commercial real estate

2.1. Indicators on the physical CRE market

CRE indicators on the physical market can be obtained through:

(a) public sources, e.g. national statistical agencies or land registers; or

(b) private sector data providers that cover a substantial part of the CRE market.

The ESRB Report on commercial real estate and financial stability in the EU provides an overview of available price indices and possible data sources (7).

2.2. Indicators on the financial system's CRE exposure

The exposures of market participants, at least those of the financial sector, can be collected from supervisory reporting. Some data are already collected by the ECB and EIOPA at national level. However, these are not very detailed. New supervisory reporting templates for banks, i.e. Financial Reporting (FINREP) and Common Reporting (COREP), for insurers under Directive 2009/138/EC of the European Parliament and of the Council (8) and for investment funds under Directive 2011/61/EU of the European Parliament and of the Council (9) can provide more granular insight into financial institutions' exposures to CRE.

The classifications provided in the statistical classification of economic activities in the European Community (NACE rev 2.0) can be useful to proxy financial institutions' exposures to CRE, as they are widely agreed upon by the Union institutions and used in regulatory reporting templates for banks and insurance undertakings. Two sections appear to be relevant in that respect:

(a) Section F: construction, excluding civil engineering; and

(b) Section L: real estate activities, excluding real estate agencies.

The main drawback of using NACE classifications is that they target economic sectors and not loans. For instance, a loan extended to a property company to buy a car fleet will be reported under Section L, even if it is not a CRE loan.

2.3. Use of private sector data

Where national macroprudential authorities use data from a private sector data provider in order to compile the CRE indicators, they are expected to identify the differences in scope and definitions compared to those requested in this Recommendation. They should also be able to provide details on the underlying methodology used by the provider and the sample coverage. Data from a private sector provider should be representative of the overall market and the relevant breakdowns set out in Recommendation D:

(a) property type;

(b) property location;

(c) investor type and nationality;

(d) lender type and nationality.

3. Relevant breakdowns of the indicators

With respect to the relevant breakdowns set out in Recommendation D, national macroprudential authorities should be able to provide an assessment of the relevance of such breakdowns for their CRE market when they use them for monitoring purposes, taking also into account the principle of proportionality.

‘Property type’ refers to the primary use of a commercial property. For CRE indicators, this breakdown should include the following categories:

(a) residential, e.g. multi-household premises;

(b) retail, e.g. hotels, restaurants, shopping malls;

(c) offices, e.g. a property primarily used as professional or business offices;

(d) industrial, e.g. property used for the purposes of production, distribution and logistics;

(e) other types of commercial property.

If a property has a mixed use, it should be considered as different properties (based for example on the surface areas dedicated to each use) whenever it is feasible to make such breakdown; otherwise, the property can be classified according to its dominant use.

‘Property location’ refers to the geographical breakdown (e.g. by regions) or to real estate sub-markets, which shall also include prime and non-prime locations. A prime location is generally considered the best location in a particular market, which is also reflected in the rental yield (typically the lowest in the market). For office buildings this could be a central location in a major city. For retail buildings this may refer to a city centre with many pedestrians or a centrally-placed shopping centre. For logistics buildings this may refer to a location where the necessary infrastructure and services are in place, which has excellent access to transport networks.

‘Property territory’ refers to the territory where the property that serves as collateral for a loan provided within the domestic financial system of any Member State is located. This breakdown should include the following sub-categories:

(a) domestic territory;

(b) foreign territory broken down into individual countries which the national macroprudential authorities of the Member State deem important for financial stability purposes.

‘Investor type’ refers to broad investor categories, such as:

(a) banks;

(b) insurance companies;

(c) pension funds;

(d) investment funds;

(e) property companies;

(f) others.

It is probable that only data on the recorded borrower or investor will be available. However, national macroprudential authorities should be aware that the recorded borrower or investor can be different from the ultimate borrower or investor, which is where the final risk lies. Hence, authorities are encouraged to monitor also information on the ultimate borrower or investor whenever possible, e.g. through information gathered from market participants, in order to have a better understanding of the behaviour of market participants and risks.

‘Lender type’ refers to broad lender categories, such as:

(a) banks, including ‘bad banks’;

(b) insurance companies;

(c) pension funds.

National macroprudential authorities may need to adjust the list of investor and lender types in order to reflect the characteristics of the local CRE sector.

‘Nationality’ refers to the country of incorporation of the market participant. The nationality of investors and lenders should be broken down into at least the three following geographical categories:

(a) domestic;

(b) rest of the European Economic Area;

(c) rest of the world.

National macroprudential authorities should be aware that the recorded investor's or lender's nationality can be different from the nationality of the ultimate investor or lender where the final risk lies. Hence, authorities are encouraged to also monitor information on the ultimate lender's or investor's nationality, e.g. through information gathered from market participants.

The breakdowns set out in Recommendation D(2) are to be considered as the recommended minimum. However, national macroprudential authorities are not prevented from making use of any additional breakdowns which, based on their own definitions and metrics, and taking into consideration the specificities of their national CRE markets, they may deem necessary for financial stability purposes. With respect to these additional breakdowns, national macroprudential authorities may choose to monitor and categorise these market segments as they deem appropriate for their national CRE markets. Moreover, where certain sub-categories of CRE or RRE are not deemed to be of relevance for financial stability purposes, national macroprudential authorities may choose not to monitor the risks stemming from such types of property and/or from their financing. In such cases, inaction by national macroprudential authorities will be deemed to be justified provided that sufficient explanations are provided.

4. Methods for calculating the physical market indicators

CRE price refers to a constant quality numéraire, i.e. the market value of property stripped of quality changes such as depreciation (and obsolescence) or appreciation (e.g. renovation) by means of quality adjustment.

Guidance from work initiated by Eurostat advises that pricing data should be collected from actual transactions. Where these are not available and/or fully representative they may be approximated by appraisal or valuation data as long as these data reflect the current market price, and not any sustainable price measurement approach.

5. Assessment of financial system exposures to commercial real estate

The financial system's exposure to CRE consists of both lending, often by banks and sometimes also insurance companies, and investments, often made by insurance companies, pension funds and investment funds. Investments can refer to both direct CRE holdings, e.g. possessing legal title to a CRE property, and indirect CRE holdings, e.g. through securities and investment funds. In case a lender or investor uses a special purpose vehicle (SPV) as a dedicated CRE financing technique, such lending or investments should be considered as direct CRE lending or holdings (‘look-through’ approach).

When assessing these exposures for the system, as a whole, national macroprudential authorities should be aware of the risk of double-counting. Investors can invest both directly and indirectly in CRE. For example, pension funds and insurance companies often invest indirectly in CRE.

It may also be more difficult to capture exposures of foreign market participants, which may make up a significant part of the market (10). Since these market participants are important to the functioning of the CRE market, monitoring of their activities is advisable.

Since losses from CRE activities are often concentrated in CRE lending by banks, national macroprudential authorities are encouraged to pay particular attention to this activity in their monitoring.

6. Methods for calculating LTV

Annex IV sets out the methods for calculating LTV-O and LTV-C. However, there are a number of specificities to take into account when these ratios are calculated for CRE.

In the case of a syndicated loan, the LTV-O should be calculated as the initial amount of all loans granted to the borrower relative to the value of the property at origination. Where several properties are concerned, the LTV-O should be calculated as the ratio of the initial loan(s) amount to the total value of the properties concerned.

As the number of properties is much smaller and properties are more heterogeneous in the CRE sector than in the RRE sector, it is more appropriate to calculate the LTV-C on the basis of a value assessment of the individual properties rather than using a value or price index.

Finally, national macroprudential authorities need to monitor the distribution of LTV with a particular focus on the riskiest loans, i.e. those with the highest LTV, as losses often result from such tail risk.

7. Methods for calculating the interest coverage ratio (ICR) and debt service coverage ratio (DSCR)

The interest coverage ratio (ICR) and the debt service coverage ratio (DSCR) refer to rental income generated by an income-producing property or set of properties, or to cashflow generated by the conduct of the business, purpose or activity of the owners of a property or set of properties, net of taxes and operating expenses that the borrower must incur in order to maintain the property's value and – in the case of cashflow – adjusted for other costs and benefits directly connected with the use of the property.

ICR is defined as:

For the purposes of calculating ICR:

(a) ‘net annual income’ includes the annual rental income accruing from renting property to tenants or the annual cashflow generated by the conduct of the business, purpose or activity of the owners of the property, net of taxes and any operational expenses to maintain the property's value and – in the case of cashflow – adjusted for other costs and benefits directly connected with the use of the property.

(b) ‘annual interest costs’ are annual interest costs associated with the loan secured by the CRE property or set of properties.

The ICR's purpose is to measure the extent to which the income generated by a property is sufficient to pay for the interest expenses incurred by a borrower to purchase that property. ICR should therefore be analysed at property level.

DSCR is defined as:

For the purpose of calculating DSCR:

(a) ‘net annual income’ is the annual rental income accruing from renting property to tenants or the annual cashflow generated by the conduct of the business, purpose or activity of the owners of the property, net of any taxes and operational expenses to maintain the property's value and – in the case of cashflow – adjusted for other costs and benefits directly connected with the use of the property.

(b) ‘annual debt service’ is the annual debt service associated with the loan secured by the CRE property or set of properties.

The DSCR's purpose is to assess the weight of the overall debt burden that a property generates for a borrower. Hence, the denominator includes not only interest expenses, but also loan amortisation, i.e. principal repayments. The main issue for such an indicator is whether it should be calculated at property level or at borrower level. CRE financing is typically provided on a non-recourse basis, i.e. the lender is only entitled to repayment from the income of the property and not from the borrower's other income or assets. Therefore it is more realistic and appropriate to calculate the DSCR at property level. Furthermore, focusing on a borrower's overall income would raise important consolidation issues which would make it more difficult to define a metric that is comparable across Member States.

8. Additional indicators relevant for income-producing property under development

For income-producing property under development, instead of the LTV at origination, national macroprudential authorities may instead monitor the loan-to-cost ratio (LTC). The LTC represents the initial amount of all loans granted in relation to the costs associated with the construction of the property until completion.

In addition, national macroprudential authorities should focus their monitoring on the riskiest developments, e.g. those that experience very low pre-let or pre-sale ratios. For any building still being constructed, the pre-let ratio equals the surface area that has already been let by the property developer at the time the loan is issued relative to the total surface area that will be available once the property has been completed; similarly, the pre-sale ratio equals the surface area that has already been sold by the property developer at the time the loan is issued relative to the total surface area that will be available once the property has been completed.

9. Annual publication of commercial real estate exposures by the ESAs

Drawing on information available from regulatory reporting templates, the ESAs are recommended to disclose at least annually aggregated information on the exposures to the different national CRE markets in the Union for the entities within the scope of their supervision and on solo basis. Such public disclosure is expected to enhance the knowledge of national macroprudential authorities on the activity of entities from other Member States on their domestic CRE market. In case there are any concerns about the scope or quality of the published data, such publication should be accompanied with the appropriate comments.

As a general rule, the ESAs should make it possible for any national macroprudential authority in the Union to assess the exposures of all Union financial institutions to its national market. This implies that data collected for all financial institutions in the Union should be aggregated at country level.

In disclosing such aggregated information, the ESAs should make use of information in regulatory reporting templates that provide a geographical breakdown of credit exposures and/or (direct and indirect) investments. When reporting templates provide a breakdown by NACE codes (11), CRE could be referred to as both the ‘F’ and ‘L’ Sections, although strictly speaking some sub-categories would need to be excluded following the CRE definition adopted in this Recommendation.