A view of Downtown San Diego, where office buildings share space with hotels and residential towers. Photo credit: Screen shot, sandiegobusiness.org
The commercial real estate market is facing a pressing question: how secure are the investments in bricks and mortar if the way people shop and work undergoes a permanent change? Analysts, academics, and investors are cautioning that the traditional approach of waiting for rental demand to rebound and interest rates to decrease may not be effective this time around.
Caption: City skyline at sunset
With remote work becoming the norm for many office-based businesses and the widespread adoption of online shopping, major cities like London, Los Angeles, and New York are left with surplus buildings that are no longer in demand. The recovery of city-center skyscrapers and large malls may take significantly longer, and landlords and lenders may face more substantial losses.
According to Richard Murphy, a political economist and professor of accounting practice at the U.K.'s Sheffield University, employers are realizing that the need for massive office facilities is diminishing, which should concern commercial landlords. Experts suggest that investors in commercial property pull out sooner rather than later.
Moody's Investors Service reported that global banks hold approximately half of the $6 trillion in outstanding commercial real estate debt, with a significant portion maturing between 2023 and 2026. U.S. banks have already experienced escalating losses from their property holdings in the first half of this year and anticipate further losses. The credit risk assessments supplied by global lenders to U.S. industrial and office real estate investment trusts (REITs) indicate that these firms are now 17.9% more likely to default on their debt than estimated six months ago.
Jeffrey Sherman, deputy chief investment officer at DoubleLine, warns that some U.S. banks are cautious about allocating liquidity towards commercial property refinancing in the next two years due to potential deposit flight. Customers are increasingly moving their deposits to higher-yielding "risk-free" money market funds and Treasury bonds. Sherman believes this situation is a ticking time bomb as long as the Federal Reserve keeps interest rates high.
Despite these concerns, some global policymakers remain optimistic that the shift in the perception of what it means "to go to work" will not lead to a credit crisis like that of 2008-09. Demand for loans from euro zone companies has reached record lows, and annual Federal Reserve "stress tests" indicate that banks, on average, expect a lower projected loan loss rate in 2023 than in 2022, even under an extreme scenario of a 40% drop in commercial real estate values.
While average commercial property values in the U.K. have already declined by approximately 20% from their peak without causing significant loan impairments, experts warn that aggressive rate tightening could lead to severe consequences. Charles-Henry Monchau, Chief Investment Officer at Bank Syz, likens the impact of rate tightening to dynamite fishing, suggesting that the smaller losses will occur first, followed by more significant losses from commercial real estate.
Jones Lang LaSalle (JLL), a global property services firm, highlighted an 18% annual drop in global leasing volumes in the first quarter of this year. Their recent data shows negative prime office rental growth in key cities like New York, Beijing, San Francisco, Tokyo, and Washington D.C. In Shanghai, office vacancy rates rose to 16% in the second quarter, indicating that recovery will depend on successful nationwide stimulus policies.
In addition to changing demand, businesses are under pressure to reduce their carbon footprint. HSBC, among others, is cutting the amount of space they rent and terminating leases at offices that are no longer considered environmentally friendly. Retrofitting over 1 billion square meters of office space globally by 2050 will be necessary to meet net-zero targets, with a tripling of current retrofitting rates.
Amidst these uncertainties, Australia's largest pension fund, AustralianSuper, has decided to suspend new investments in unlisted office and retail assets due to poor returns. Additionally, short-sellers have targeted listed property landlords worldwide, betting on declining stock prices.
Capital Economics forecasts global property returns of around 4% per year this decade, compared to an average of 8% before the pandemic. They suggest that investors must adjust their expectations and accept a lower property risk premium.
The commercial real estate market is undoubtedly facing challenging times ahead. While there are differing opinions about the severity of the impact, it is crucial for investors and stakeholders to remain vigilant and adapt to the evolving landscape.
By Sinead Cruise, Lucy Raitano, and Lewis Jackson with additional reporting by Dhara Ranasinghe and Huw Jones in London and Clare Jim in Hong Kong; editing by Kirsten Donovan
