Is commercial real estate the ‘next penny to drop’?

Demand for commercial real estate has waned amid rising interest rates and changing societal norms off the back of the COVID-19 pandemic. 

This had stoked fears of an imminent shock to the financial system, with many banks, particularly in the United States, highly exposed to commercial real estate. 

AMP’s Capital chief economist, Dr Shane Oliver, said the market benefited from the record-low interest rate environment, but was now increasingly out of favour as investors sought yield in the recovering fixed income asset class.  

“The property market was a key beneficiary of the shift to ultra-low interest rates and bond yields in the decades prior to the pandemic, and that continued into the pandemic, but that’s now reversing,” he told Money Management's sister title InvestorDaily. 

“Investors allocated more money to property; it was a well-known practice in the Australian funds management industry.”

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Inflation-induced monetary policy tightening from the central banks exacerbated a dip in demand for office and retail property during the pandemic, impacted by the shift to remote work and the spike in online shopping activity. 

Oliver observed that in Australia, office vacancy rates rose to 15 per cent across the five largest capital cities in 2022.

“The risk is vacancy rates will increase, and that’s a similar story in other countries,” he added. 

According to data from the Property Council of Australia, in Sydney’s CBD alone — Australia’s largest commercial property hub — the office vacancy rate hit 11 per cent as at 31 December 2022. 

Sydney CBD vacancies were set to lift higher over the course of 2023, with BIS Oxford Economics projecting a vacancy rate of 13 per cent by year’s end. 

“It’s obviously being impacted by the shift to hybrid working, but we’re also seeing weaker employment growth come through as economic growth slows down this year and next year,” Lee Walker, principal property economist at Oxford Economics, told InvestorDaily. 

“We don’t really think there’s going to be much by way of demand for office space this year and next, which ultimately leads to fairly modest rental growth.”

Rental yields were tipped to fall by a further 85 basis points over the next eight months, which Walker said could result in a 15 per cent fall in capital values. 

But he said, there would be limited impact on Australian banks, given property owners were less highly leveraged than they were before the Global Financial Crisis.  

“[Australian banks] certainly have more headroom to go before breaking lending covenants this time around,” Walker said. 

“Our view is that a 15 per cent fall in capital values is unlikely to be enough to trigger forced sales from banks that have exposure to Australian commercial property. 

“We’re expecting a significantly [milder] setback to property prices in Australia, than what’s been seen overseas in the United States.”

Gloomier outlook for US banks
US regional banks, on the other hand, are “high risk”, according to AMP’s Shane Oliver, and could be the “next penny to drop”. 

According to a recent analysis by asset manager Quay Global Investors, the US banking sector is exposed to approximately US$3 trillion in commercial real estate loans ($4.5 trillion). 

Smaller, “less capitalised” banks bore the lion’s share of this debt burden on their balance sheets, with approximately US$2 trillion ($3 trillion) in exposure to the commercial property market. 

“They’re already under stress because their deposit base is shifting to the larger, more secure banks,” he said. “To some degree, they can borrow money from the Federal Reserve, but they’re borrowing money at 5 per cent and a lot of the loans they have out there are yielding less than 5 per cent.

“So, their interest margin is under intense pressure.”

Among the US banks with elevated exposure to commercial real estate is New York Community Bancorp, which recently absorbed assets managed by local peer Signature Bank, which famously collapsed in March. 

Other highly exposed regional banks like M&T Bank, Comerica, and Zions Bancorp have borne the brunt of weakening investor confidence, with their share prices falling as much as 41 per cent over the past six months.

“Given the threat that commercial property poses to those banks, it’s way too early to say the banking crisis is over or the banking stress is over,” Oliver said. 

Oliver said investors should limit their exposure to smaller lenders. 

“If you are going to invest in banks, invest in the bigger ones that have got more protections,” he said.

But even larger players were bracing for a potential hit to their balance sheets. 

Charlie Scharf, chief executive of banking giant Wells Fargo, recently revealed the lender had set aside US$643 million ($963 million) in capital over the first quarter of 2023 for potential credit losses, “mainly driven by expectations of higher commercial real estate loan losses”.

Recent volatility in the banking sector had also reshaped forecasts for the macroeconomic outlook, prompting the International Monetary Fund (IMF) to revise its global economic growth projections.

The IMF was now anticipating world output of 2.8 per cent in 2023 before picking up to 3 per cent in 2024. The fund’s January projections had forecast global output of 2.9 per cent in 2023 and 3.1 per cent in 2024. 

“Side effects from the fast rise in policy rates are becoming apparent as banking sector vulnerabilities have come into focus and fears of contagion have risen across the broader financial sector, including non-bank financial institutions,” the fund added.

Last month, three US banks — Silicon Valley Bank (SVB), Silvergate Capital, and Signature Bank — collapsed under the pressure of higher debt servicing costs, which drained liquidity stocks that were already depleted by overexposure to long-term bonds.  

Swiss banking giant Credit Suisse faced similar challenges before being rescued by an emergency takeover from rival UBS. 

“We are therefore entering a perilous phase during which economic growth remains low by historical standards and financial risks have risen, yet inflation has not yet decisively turned the corner,” the IMF continued.

“More than ever, policymakers will need a steady hand and clear communication. The appropriate course of action is contingent on the state of the financial system.”-