Commercial real estate investors and banks prepare for property storm
Commercial real estate investors and banks prepare for property storm
The Future of Commercial Real Estate: A Changing Landscape
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Commercial real estate investors and lenders are facing a daunting question: If people never again shop in malls or work in offices the way they did before the pandemic, how safe are the ANBLEs they piled into bricks and mortar?
In the wake of rising interest rates, stubborn inflation, and uncertain economic conditions, seasoned commercial property buyers, who are used to weathering storms, are now concerned that rental demand might not rally and borrowing costs might not decrease as they have in the past. This time, things could be different.
With remote working becoming the norm for many office-based firms and online shopping becoming a habit for consumers, cities like London, Los Angeles, and New York are facing an oversupply of buildings that are no longer desired or needed by the local population. As a result, the values of city-center skyscrapers and sprawling malls are expected to take much longer to rebound. Landlords and lenders now risk experiencing more significant losses than in previous cycles if they can’t find tenants for their properties.
“Employers are beginning to appreciate that building giant facilities to warehouse their people is no longer necessary,” says Richard Murphy, political ANBLE and professor of accounting practice at Sheffield University. “Commercial landlords should be worried. Investors in them would be wise to quit now.”
The Wall of Debt
The concern around commercial real estate is not unfounded. According to Moody’s Investors Service, global banks hold about half of the $6 trillion outstanding commercial real estate debt, with a significant portion maturing between 2023 and 2026. U.S. banks have already disclosed growing losses from property investments in their first-half figures and warned of more to come.
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Credit risk assessments from global lenders and data providers reveal that firms in the industrial and office real estate sector are now 17.9% more likely to default on debt than estimated just six months ago. This alarming trend has made some U.S. banks wary of tying up liquidity in commercial property refinancing due in the next two years. The potential flight of customer deposits to higher-yielding investments could exacerbate this situation further.
However, policymakers are still optimistic that the shift in how people view going to work post-pandemic will not result in a credit crisis similar to that of 2008-2009. Demand for loans from euro zone companies has hit a record low, and the annual U.S. Federal Reserve stress tests indicate that banks would suffer a lower projected loan loss rate in 2023 compared to 2022, even under extreme scenarios.
It’s worth noting that average UK commercial property values have already fallen by approximately 20% from their peak, without causing significant loan impairments. UK banks also have far smaller property exposure compared to 15 years ago.
However, Charles-Henry Monchau, Chief Investment Officer at Bank Syz, warns that aggressive rate tightening is like dynamite fishing, where the small fishes come to the surface first, followed by the bigger ones. Only time will tell if commercial real estate in the U.S. is the metaphorical “whale” in this scenario.
Cutting Space and Retrofitting
The challenges facing commercial real estate extend beyond the potential financial risks. Businesses are under pressure to reduce their carbon footprint, leading to a decrease in office space demand. Large companies like HSBC are actively cutting the amount of space they rent and terminating leases for offices that no longer meet sustainability criteria.
Jones Lang LaSalle (JLL), a global property services firm, reported an 18% annual drop in first-quarter global leasing volumes. Prime office rental growth in major cities like New York, Beijing, San Francisco, Tokyo, and Washington D.C. has turned negative. In Shanghai, the office vacancy rate rose by 1.2 percentage points year-on-year in Q2 to 16%.
To meet net-zero targets, over 1 billion square meters of office space globally will need to be retrofitted by 2050, requiring a tripling of the current retrofitting rates. The need for better environmental practices is influencing investment decisions, with Australia’s largest pension fund, AustralianSuper, suspending new investments in unlisted office and retail assets due to poor returns.
As the challenges pile up, short-sellers are targeting listed property landlords worldwide, betting that their stock prices will decline. The volume of real estate stocks lent by institutional investors to support shorting activity has increased significantly. Capital Economics projects an average property return of around 4% per year this decade, compared to the pre-pandemic average of 8%. The once-thriving commercial real estate sector now appears overvalued by historical standards.
While the future might appear uncertain for commercial real estate, there is still hope. Adaptation and innovation will be crucial for developers, owners, and investors in navigating this new landscape. The industry must find creative ways to repurpose properties and cater to the changing needs of the workforce and consumers, whether through mixed-use developments, flexible office spaces, or transforming malls into entertainment hubs.
However, caution remains necessary, as the risks associated with the shifting commercial real estate market are significant. Investors and lenders must tread carefully, assess their portfolios, and make strategic decisions to mitigate potential losses. The next few years will undoubtedly be a crucial period for the industry, presenting both challenges and opportunities for those involved in the world of commercial real estate.
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