Securities markets generally, and the asset management industry in particular, are highly exposed to risks of growing stress in the real-estate sector, according to a new report from the European Securities and Markets Authority (ESMA).

The regulator published its first examination of the financial markets exposure to real estate, finding an array of risks amid high debt levels, rising credit risks, and liquidity risks for investment funds.

The report noted that the regulators’ analysis of the securities and asset-management industries’ exposures to the real-estate sector “suggests that sizeable vulnerabilities exist” and that negative shocks to the real-estate sector could be transmitted across the broader financial system through both banks and non-bank financial institutions.

Growing stress in the real-estate sector has already impacted securities markets through declines in equity and bond indexes, and eroding investor confidence, the report said, adding that investment funds have increased their exposure to real estate in recent years too.

Indeed, assets under management for real estate-focused alternative investment funds have grown 375% to €1.5 trillion over the past five years, it reported.

“Leverage of real-estate firms increased significantly over the past five years,” it said, adding that investment funds are also major investors in the real-estate sector, and are among the main counterparties to real-estate firms in derivatives and securities financing transactions.

Amid the elevated interest rate environment, and slowing economic growth, the real-estate sector is expected to continue facing stressed conditions, the report said, adding that “this will also translate into challenges for non-bank real-estate financial market players.”

Looking ahead, “interest rate risk can be expected to continue to shape real-estate market exposures,” ESMA said, adding that credit-risk indicators for real-estate companies have begun to show signs of deterioration, while liquidity mismatches remain the key vulnerability for real-estate funds.

“Mismatches in liquidity profiles increase the risk of further pressures on asset valuations in times of stress, if investment funds seek to sell less liquid assets over a short period to meet redemptions,” the report said.