Investors are questioning the health of the commercial real estate sector following a series of recent banking crises.
Mike Kemp | In pictures | Getty Images
Concerns are growing around the health of the European commercial property market, with some investors wondering if it could be the next sector to blow up after last month’s banking crisis.
Rising interest rates have raised the cost of borrowing and depressed valuations in the real estate sector, which in recent years has reigned supreme in an environment of low bond yields.
Meanwhile, the March collapse of US-based Silicon Valley Bank and the subsequent emergency rescue of Credit Suisse raised fears of a so-called “catastrophic loop”, in which a possible bank run could trigger a downturn in the real estate sector.
Earlier this month, the European Central Bank warned of “clear signs of vulnerability” in the real estate sector, citing “lower market liquidity and price corrections” as reasons for the uncertainty, and calling to news curb commercial real estate funds reduce the risks of illiquidity crisis.
Already in February, European funds investing directly in real estate saw outflows of £172m ($215.4m), according to Morningstar Direct data – a stark contrast to inflows of almost 300m. sterling observed in January.
Citi analysts now see European property stocks falling 20% to 40% between 2023 and 2024 as the impact of rising interest rates is felt. In the worst-case scenario, the high-risk commercial real estate sector could plummet by 50% by next year, the bank said.
A calculation for office space
The office segment – a major component of the commercial real estate market – has become a central part of potential downturn fears given broader shifts towards remote or hybrid working models in the wake of the Covid pandemic.
“People are concerned that the return to the office hasn’t really materialized, so there are too many vacancies and yet there are too many loans in this area as well,” said Ben Emons, principal and senior strategist. of the portfolio at US investment manager NewEdge Wealth, CNBC’s “Squawk Box Europe” told CNBC last month.
People are trying to figure out which banks have lent where, to which sector, and what the ultimate risk really is.
Principal and Senior Portfolio Strategist at NewEdge Wealth
This heightened concerns about which banks could be exposed to such risks and whether a wave of forced selling could lead to a downward spiral.
According to Goldman Sachs, commercial real estate represents approximately 25% of American banks’ loan portfolios – a figure that reaches as high as 65% among smaller banks, at the center of recent stressors. This compares to around 9% among European banks.
“I think people are trying to figure out which banks have lent where, to which sector, and what the ultimate risk really is here,” Emons added.
Amid this uncertainty and what it called stretched valuations, Capital Economics last month increased its forecasts for a 12% to 20% peak-to-trough correction in the Eurozone real estate sector, with offices expected to fare the worst.
“We see this financial distress, or whatever you want to give him, as a catalyst for a deeper value adjustment than previously expected,” said Kiran Raichura, Deputy Chief Real Estate Economist at Capital Economics, in a recent webinar.
Risks in Europe less acute than in the United States
However, not everyone is convinced of a coming downturn.
Pere Vinolas Serra, chief executive of Spanish property company Inmobiliaria Colonial and president of the European Public Real Estate Association (EPRA), said the situation in Europe seemed paradoxically strong.
Among the various factors at play, the return-to-office trend has been stronger in Europe than in the United States, he said, while rates of “taking over” – or occupancy – of offices were higher on the mainland.
“What’s striking is that the data shows it’s better than ever,” Vinolas told CNBC via Zoom. “Something totally different is happening in the United States compared to Europe.”
European funds investing directly in real estate saw outflows of £172m against inflows of almost £300m in January, according to data from Morningstar Direct.
Westend61 | Getty Images
At the end of 2022, the office vacancy rate in Europe stood at around 7%, well below the 19% in the United States, according to real estate adviser JLL. Within the Inmobiliaria Colonial portfolio, Vinolas said current vacancy rates were even lower, at 0.2% in Paris and 5% in Madrid.
“I’ve never seen this in my life. The data on occupancy rates is at the highest level,” Vinolas said.
JP Morgan echoed that view late last month, saying in a research note that fears of a US slowdown spreading to Europe were overblown.
“Fundamentally, we believe that any contagion from US banks or US CRE (commercial real estate) to European peers is unwarranted, given the different sector dynamics,” the bank’s analysts said.
Future uncertainties and opportunities
Still, uncertainties remain in the sector, analysts have warned.
Of particular concern is the concentration of funding from non-bank lenders – or so-called ghost banks – which have taken over following tougher regulation on traditional banks, said Matthew Pointon, senior real estate economist at Capital Economics.
Before the global financial crisis, traditional European banks offered loans of 80% of the value of a building. Today, they rarely exceed 60%.
The challenge will be for unsophisticated players, those who have a building they need to adapt.
Father Vinolas Serra
managing director of Inmobiliaria Colonial
“We know much less about these [shadow banks], and they may be more vulnerable to rising interest rates, for example. It is therefore an unknown that could put a brake on the work,” said Pointon.
In the meantime, new EU and UK energy efficiency standards will require significant investment, particularly in older buildings, and could see some property owners come under additional pressure over the next few years.
“I think the challenge will be for unsophisticated players, those who have a building that they need to adapt to the new requirements,” Vinolas said.
“At this level – which is important by the way – there could be a huge impact but also huge opportunities,” he added.