FRANKFURT (Reuters) - The euro zone's commercial real estate market could struggle for years, leaving bank loan books, investment funds and insurers exposed, the European Central Bank said on Tuesday.

Economic weakness and high interest rates have depressed real estate prices over the last year, reducing real estate firms' profitability and even challenging the commercial property market's business model.

The sector is not big enough to create a systemic risk for lenders but could increase shocks across the financial system and greatly impact the financial firms, from investment funds to insurance firms, collectively known as shadow banks.

"While the relatively limited size of bank commercial real estate portfolios implies that they are unlikely on their own to lead to a systemic crisis, they could play a significant amplifying role in the event of broader market stress," the ECB said in a Financial Stability Review article.

Residential mortgages make up about 30% of bank loan books, while commercial real estate accounts for about 10%.

"A negative outcome of this type would also drive large losses in other parts of the financial system which are significantly exposed to CRE, such as investment funds and insurers," it added.

Commercial real estate transactions were down 47% in the first half of 2023, compared with the same period a year earlier.

That makes it hard to say how far prices have dropped, but the bloc's largest listed landlords are trading at a discount of over 30% to net asset value, their largest such discount since 2008, the ECB said.

It said a sample of bank loans to real estate firms implies the recent rise in financing costs may cause the share of loans extended to loss-making firms to double to as much as 26%.

If the tighter financing conditions persist for two years as markets expect, and firms are required to roll over all maturing loans, this number would increase to 30%.

"There are substantial vulnerabilities in this loan book, particularly when considering that it is expected that both higher financing costs and reduced profitability will persist for a number of years," the ECB said.

"Business models established on the basis of pre-pandemic profitability and low-for-long interest rates may become unviable over the medium term."

Commercial real estate market could struggle for years, ECB says 1