Asset managers have long seen real estate as an effective hedge against inflation. However, these are not normal times: over the next two years, economists and investors are predicting an enormous right-sizing of asset prices in the commercial property sector to the tune of hundreds of billions of dollars.
It is difficult to overstate the significance of such a change. According to McKinsey, in six of the previous seven inflationary periods between 1980 and 2022, US commercial real estate (CRE) outperformed inflation and generally fared better than equities, BBB-rated corporate bonds and US treasuries. The asset class even trumped gold.
Yet the past 40 years have been something of an aberration in economic terms: a time of gradually declining interest rates. Today, monetary policy is tightening at breakneck speed with central banks raising rates at the fastest pace in decades from a starting point of low-to-near-zero.
Previously, investors could reliably refinance their properties at low interest rates, building higher and higher multiples of debt, while watching the nominal value of their holdings rise in a booming real estate market. These balance sheets were not built to last and for many investors, particularly in office spaces, that will spell disaster.
“The end to the low inflation, low interest rate environment has ushered in a new era of real estate investing, where property owners need the operational expertise to generate the rental incomes to meet their mortgage payments,” says Tom Leahy, head of Europe, the Middle East and Africa real assets research at analytics firm MSCI.
The end to the low inflation, low interest rate environment has ushered in a new era of real estate investing
Mark Unsworth, associate director of European real estate economics at Oxford Economics, agrees. He argues that “lending conditions are unlikely to improve in the near term”, as central banks will need to see “clear and sustained evidence that inflation is heading back to target before interest rates can peak”.
If that happens, he is optimistic that the situation could begin to improve next year as the US Federal Reserve and Bank of England (BoE) ponder rate cuts, and CRE valuations find a floor. In the meantime, however, financing markets will remain largely dormant, curbing the tendency towards ever higher asset valuations.
Impact of bank runs
The first signs of stress resulting from hikes to the benchmark rate came in March, when a series of bank runs at Silicon Valley Bank, First Republic and Signature Bank prompted fears of a wider contagion — the latter two banks being the then ninth and 10th largest lenders to the US commercial property sector.
When Signature Bank failed, New York Community Bank set off alarm bells by acquiring the majority of the lender’s assets, with the notable exception of its $35bn CRE portfolio.
This put an asterisk next to the loan books at other small banks, which account for 70% of total CRE lending ($2.9tn) and are on average 4.4 times more exposed to the sector than their Wall Street peers, such as JPMorgan and Wells Fargo. Taken together, banks are facing what Goldman Sachs analysts have called a “perfect storm”: higher default risk of CRE loans and a sharp adjustment in property valuations, alongside increased funding costs and compressed net interest margins.
The hedge fund Man Group has warned that US CRE will “be the next domino to fall as the banking crisis comes off a boil”, arguing that the renewed focus on liquidity among banks could further tighten lending conditions.
Stressed markets
Cracks have already started to appear in the public markets for CRE assets. While private market price indices are “notoriously backward looking”, says Stijn Van Nieuwerburgh, a professor of real estate at Columbia Business School, it is possible to track concerns over falling valuations in listed securities. “We have already seen it big time in the stock prices of office real estate investment trusts (REITs). These public companies’ office properties are being repriced by investors on a daily basis, so there is no need to wait for REITs liquidating assets.”
One area of concern is office space, which has emerged as something of a bête noire for real estate investors, many of whom have been scared off by stubbornly low utilisation rates following the Covid-19 pandemic. This rate measures the number of office visits made by workers as a proxy for the underlying health of the sector, and as such includes use of existing leases as well as vacancies.
“The remote work trend is a secular change, not merely a cyclical one,” says Mr Van Nieuwerburgh. “The return to the office has stalled at 50% of pre-pandemic levels.”
The remote work trend is a secular change, not merely a cyclical one
For office owners, remote work is a double-edged sword because vacancies dampen rental growth at a time when offices require high amounts of capital expenditure to compete with the comfort and convenience of working from home. Given the length of commercial leases, there is a sense in the market that much of this pain has yet to come.
“No one knows whether banks will suffer losses on their commercial real estate loans, or what the magnitude will be,” explained Howard Marks, co-founder of Oaktree Capital Management, in a widely circulated monthly investment memo from April. “But we’re very likely to see mortgage defaults in the headlines, and at a minimum, this may spook lenders, throw sand into the gears of the financing and refinancing processes, and further contribute to a sense of heightened risk.”
At present, the US market appears most vulnerable, but the European Central Bank (ECB) and BoE have also sounded notes of caution on risks in the commercial property market in recent weeks as prices continue to deteriorate.
The US market
Overall, the direct risk posed by CRE to the $23tn US banking system is ostensibly low. CRE represents 14% of bank assets, while office space accounts for up to 4% of total asset exposure.
Yet the coming reckoning for CRE assets is on a scale not seen since the 2007–09 global financial crisis (GFC). Around $2.56tn in commercial property debt will need to be refinanced over the next four years and that will introduce a lot of stress into the system. JPMorgan estimates that the liquidation rate for commercial mortgage-backed securities (CMBS) in the US office sector will climb to 20% by the end of the decade, with loan extension options only cushioning the blow until 2025–2027.
“The gulf in pricing expectations between owners and buyers will take time to narrow to reactivate the transaction market,” says Mr Leahy. “Lenders and borrowers aren’t in a hurry to crystallise losses from lower prices/values, so it will only be when distress kicks in or lenders foreclose.”
During the GFC, the number of US home foreclosures peaked in September 2010 — a full two years after the collapse of Lehman Brothers.
Short-term refinancing challenges
The more immediate concern is the challenge of refinancing the $270bn in CRE loans that data provider Trepp estimates will come due this year. Around a fifth of those loans are tied up in office space, where the vacancy rate remains elevated from the pandemic at 18.7%, according to Allianz.
But the difficulties are not evenly spread: the Chicago, New York and San Francisco commercial property markets are much more challenged than those in the Sun Belt cities of Atlanta, Miami and Phoenix.
California has been particularly hard hit, with Los Angeles seeing a vacancy rate of 22.5% for office space in the first quarter of 2023, compared with 17% in Manhattan. In February, Brookfield defaulted on more than $750m in debt connected to two of the tallest buildings in downtown Los Angeles. This was followed by Pimco handing back the keys to seven buildings in San Francisco, New York, Boston and Jersey City from its Columbia Property Trust office REIT, at a cost of $1.7bn.
And further pain is in store: Scott Rechler, CEO of RXR Realty, another big office owner, recently told the Financial Times that the company would stop payments on some Manhattan properties as it seeks to renegotiate terms with its lenders.
In effect, office space has become a financial hot potato. Property owners desperately want to cut their losses and dispose of underperforming assets, while banks are reluctant to take on the operational costs and responsibilities of large commercial buildings, especially in a downmarket.
This puts financial institutions in the odd position of not wanting to exercise their charge and seize the collateral used to secure loans in the first place. Mr Leahy suspects these dynamics will likely lead to delayed foreclosures, as lenders grant borrowers short-term forbearance, or even allow the loans to be modified.
However, a more radical solution may be required to clear the glut of excess office space. Mr Van Nieuwerburgh is “fairly bullish” on the potential for some brown class B/C office buildings (i.e. older properties in need of renovation or upgrades) to be converted to multifamily residential units as a way of alleviating the housing shortage and sparing carbon emissions on new construction.
His research has found that about 15% of office buildings in the commercial districts of the 105 largest cities in the US are physically suitable for conversion, though he recognises “challenges abound” in seeing this policy through to fruition.
The European market
Unlike the US, most European CRE debt is held by big banks and less of it is traded in the public markets in the form of CMBS. Meanwhile, European workers have also been quicker to return to the office, resulting in fewer vacant office units. However, there are still areas of stress.
Most notably, deal-making activity has collapsed, hitting an 11-year low in the first quarter of 2023. According to MSCI data, there were €36.5bn worth of deals that quarter, a decline of 62% from the same period last year, as borrowing costs skyrocketed. Given these and other market forces at play, Allianz forecasts CRE prices in the eurozone to fall by between 10% and 15% over the next 12 months.
However, events across the Atlantic have not gone unnoticed by regulators. Taking note of the recent troubles faced by Blackstone Real Estate Income Trust (BREIT) and the spate of redemptions it faces, in April the ECB called for a clampdown on commercial property funds.
Between 2013 and 2022, the value of real estate investment funds (REIFs) as a proportion of the European CRE market doubled in size from 20% to 40%, with the largest increases coming in Germany, Luxembourg, France, the Netherlands and Italy.
REIFs are particularly susceptible to lower deal-making activity and transaction volumes because of the structural liquidity mismatch between their assets and liabilities, which could force them to sell off assets at severe discounts to meet redemption calls. The ECB is therefore urging funds to follow the lead of UK REIFs after last year’s gilt crisis and impose redemption gates to avoid sudden, mass outflows of capital.
Swedish CRE under strain
In a similar manner to the US, looking at the overall picture for European CRE obscures the regional impact across countries. Where French and Spanish banks hold 5% of their loan book in commercial mortgages, in Sweden that figure rises to a quarter of total bank loans, according to data from US research firm Morningstar.
“Given that it is much more exposed to CRE, Sweden is possibly more volatile and sensitive to the economic environment than other European countries,” says Charles Boissier, head of European real estate equity research at UBS.
We think that the bulk of the decline in values is behind us, but our forecast is still for office values to fall another 5% by year-end
Due to shorter-than-average debt maturities compared to its European peers, Mr Boissier infers that Swedish assets are “more mark-to-market” and have been quicker to sell at fair value.
In the year ending the first quarter of 2023, Capital Economics estimates that prime property values in Sweden have fallen by 11% in offices, 15% in retail and 19% in industrial assets.
“We think that the bulk of the decline in values is behind us, as the surge in property yields is slowing and is expected to soon stabilise as interest rates reach their peak, but our forecast is still for office values to fall another 5% by year-end,” says James McMorrow, an economist at Capital Economics.
While companies across Europe are facing higher borrowing costs, research from UBS shows that British, French, Swiss, Germany and Benelux companies have enough cash on hand to cover the next 18 months of debt maturities. In Sweden, things are less certain.
UBS projects that as much as SKr168bn ($15.5bn) in Swedish CRE debt is set to come due in 2023, leaving commercial landlords with a liquidity gap. Swedish commercial property companies Castellum and Fabege face the most challenging liquidity deficits of their European counterparts, with liquidity as a share of their market cap at –51% and –35%, respectively.
This has forced both companies to adopt cash-preserving measures. Castellum has managed to halve its liquidity gap by raising equity financing, whereas Fabege cut its dividend by 40%. One advantage for Swedish companies in the sector is that they do not tend to be structured as REITs, so they have more flexibility in curtailing dividend payments, unlike foreign companies that are often required under law to pay dividends.
Another bright spot is that Sweden’s banks have fairly manageable loan-to-value ratios at 60% and few non-performing loans. Nevertheless, there is a cost to the overleveraging of the CRE sector and it will come in due course.
“Swedish asset sales are likely to accelerate in the coming quarters, which will weigh on values,” says Mr McMorrow. “The other consequence is that investment volumes, which have declined extremely sharply in Sweden over the past few quarters, are likely to fall further this year and remain subdued in 2024.”
Mr Unsworth at Oxford Economics adds: “We forecast that it will take a decade before office capital values in Sweden return to their 2021 peak in nominal terms.”
