Analysis: Commercial real estate investors, banks buckle up for perfect property storm

Jones Lang LaSalle Incorporated

31/07/2023 24:01

By Sinead Cruise, Lucy Raitano and Lewis Jackson
       LONDON/SYDNEY, July 31 (Reuters) - Commercial real
estate investors and lenders are slowly confronting an ugly
question - if people never again shop in malls or work in
offices the way they did before the pandemic, how safe are the
fortunes they piled into bricks and mortar?
    Rising interest rates, stubborn inflation and squally 
economic conditions are familiar foes to seasoned commercial
property buyers, who typically ride out storms waiting for
rental demand to rally and the cost of borrowing to fall. 
    Cyclical downturns rarely prompt fire sales, so long as
lenders are confident the investor can repay their loan and the
value of the asset remains above the debt lent against it.
    This time though, analysts, academics and investors
interviewed by Reuters warn things could be different.
    With remote working now routine for many office-based firms 
and consumers habitually shopping online, cities like London,
Los Angeles and New York are bloated with buildings local
populations no longer want or need.
    That means values of city-centre skyscrapers and sprawling
malls may take much longer to rebound. And if tenants can't be
found, landlords and lenders risk losses more painful than in
previous cycles.
    "Employers are beginning to appreciate that building giant
facilities to warehouse their people is no longer necessary,"
Richard Murphy, political economist and professor of accounting
practice at the UK's Sheffield University, told Reuters. 
    "Commercial landlords should be worried. Investors in them
would be wise to quit now," he added.
    
    WALL OF DEBT
    Global banks hold about half of the $6 trillion outstanding
commercial real estate debt, Moody's Investors Service said in
June, with the largest share maturing in 2023-2026. 
    U.S. banks revealed spiralling losses from property in their
first half figures and warned of more to come.
    Global lenders to U.S. industrial and office real estate
investment trusts (REITs), who supplied credit risk assessments
to data provider Credit Benchmark in July, said firms in the
sector were now 17.9% more likely to default on debt than they
estimated six months ago. Borrowers in the UK real estate
holding & development category were 4% more likely to default.
    Jeffrey Sherman, deputy chief investment officer at $92
billion U.S. investment house DoubleLine, said some U.S. banks
were wary of tying up precious liquidity in commercial property
refinancings due in the next two years.
    "Deposit flight can happen any day," he said, pointing to
the migration of customer deposits from banks to higher-yielding
'risk-free' money market funds and Treasury bonds.
    "As long as the Fed keeps rates high, it's a ticking time
bomb," he said. 
    Some global policymakers, however, remain confident that the
post-pandemic shift in the notion of what it means 'to go to
work' will not herald a 2008-9 style credit crisis.
    Demand for loans from euro zone companies tumbled to the
lowest on record last quarter, while annual U.S. Federal Reserve
'stress tests' found banks on average would suffer a lower
projected loan loss rate in 2023 than 2022 under an 'extreme'
scenario of a 40% drop in commercial real estate values.
    Average UK commercial property values have already fallen by
around 20% from their peak without triggering major loan
impairments, with one senior regulatory source noting that UK
banks have far smaller property exposure as a proportion of
overall lending than 15 years ago. 
    But Charles-Henry Monchau, Chief Investment Officer at Bank
Syz likened the impact of aggressive rate tightening to dynamite
fishing.
    "Usually the small fishes come to the surface first, then
the big ones – the whales - come last," he said.
    "Was Credit Suisse the whale? Was SVB the whale? We'll only
know afterwards. But the whale could be commercial real estate
in the U.S.".
    
    CUTTING SPACE
    Global property services firm Jones Lang LaSalle  JLL.N  -
which in May pointed to a 18% annual drop in first quarter
global leasing volumes - published data this month showing prime
office rental growth in New York, Beijing, San Francisco, Tokyo
and Washington D.C. turned negative over the same period.   
    In Shanghai, China's leading financial hub, office vacancy
rates rose 1.2 percentage points year-on-year in Q2 to 16%,
rival Savills  SVS.L  said, suggesting a recovery would depend
on nationwide stimulus policies succeeding. 
    Businesses are also under pressure to slash their carbon
footprint, with HSBC  HSBA.L  among those cutting the amount of
space they rent and terminating leases at offices no longer
considered 'green' enough.
    More than 1 billion square meters of office space globally 
will need to be retrofitted by 2050, with a tripling of current
rates to at least 3%-3.5% of stock annually to meet net-zero
targets, JLL said.
    Australia's largest pension fund, the A$300 billion
AustralianSuper, is among those on the sidelines, saying in May
it would suspend new investment in unlisted office and retail
assets due to poor returns. 
    Meanwhile, short-sellers continue to circle listed property
landlords the world over, betting that their stock prices will
sink.
    The volume of real estate stocks lent by institutional
investors to support shorting activity has grown by 30% in EMEA
and 93% in North America over the 15 months to July, according
to data provider Hazeltree. 
    According to Capital Economics, global property returns of
around 4% a year are forecast this decade, compared with a
pre-pandemic average of 8%, with only a slight improvement
expected in the 2030s. 
    "Investors must be willing to accept a lower property risk
premium," Capital Economics said. "Property will look overvalued
by the standards of the past."

 (Additional reporting by Dhara Ranasinghe and Huw Jones in
London and Clare Jim in Hong Kong; Editing by Kirsten Donovan)
 ((sinead.cruise@thomsonreuters.com; 020 7513 5026; Reuters
Messaging: sinead.cruise.thomsonreuters.com@reuters.net))