Reality Check: Commercial Real Estate
Substantial Risks or Overblown Concerns?
The content of this post does not constitute financial advice. It is intended for information and education purposes only.
This is a published article on Medium where you can read the full version
Over the last couple of years, central banks around the world embarked upon a series of aggressive policy rate hikes, which inevitably affected financing costs across various market segments. As a result, commercial real estate (CRE) is now in a particularly precarious position as parts of the market have become exposed to both cyclical factors and major structural changes. The sector’s risks can be potentially amplified by the fact that there could be spillover effects across regions and countries due to the interlinks with different types of financial institutions. And while these risks are far from the global financial contagion experienced in the late 2000s during the financial crisis, they certainly should not be underestimated.
Some background
Commercial real estate includes properties such as warehouses, office buildings, retail spaces, industrial and manufacturing buildings, multifamily apartment complexes, hotels, etc. Except for apartment buildings, they are generally used for business and as such can generate income for their owners and investors. Commercial property leases are generally for longer terms than residential leases. CRE is the largest asset class after stocks and bonds.
As an investor in (commercial) real estate, one can earn from regular income (i.e., rental/lease payments including lease renewals) and/or asset appreciation (i.e., successful property projects could, usually in the long run, have a higher selling price than the aggregate investments in them). However, there are many different forms of investing in real estate, an overview of which is given in the chart below. They offer different risk and return characteristics and encompass both debt and equity investments, which can include private investment structures or public investment vehicles and instruments.
Generally, more than half of the returns from CRE investments are from regular income — and they are more consistent during the different phases of the economic cycle. In terms of debt vs. equity financing, there are some key differences to keep in mind, for instance, related to the ownership and control of the property, the repayment obligations, profit and risk sharing arrangements between the borrower/owner and the investor(s), etc. Most CRE investments involve some combination of debt and equity, with the proportions depending on the type of real estate or the specific project.
A key characteristic of the CRE market is that it relies heavily on debt funding. An example of the capital structure for a privately funded CRE deal is provided below, in addition to an example of a Commercial Mortgage-Backed Security/CMBS (simplified examples).
Per data from Apollo, in the United States, banks are the biggest lenders in the CRE space, followed by federal agencies, insurance firms, and CMBS. And the various lenders are, in fact, interconnected to an extent. For instance, non-bank creditors usually rely on warehouse lines of credit provided by banks; banks originate loans with the expectation that a CMBS execution will help repay the loans in the near term; at the same time, banks and insurers are among the largest buyers of senior CMBS, so bank balance sheet liquidity has an impact on CMBS market liquidity.
The nature of the problem
First of all, let me start with the obvious — this is not Subprime Lending, Vol.2. The overall picture shows that CRE debt and its performance have not (yet) reached proportions that would make it a systemic risk for the US or global financial system. Delinquencies are still much lower compared to the 2008–2010 period. However, the risks should not be underestimated as the commercial property market is going through a major correction and structural changes. According to the IMF, since March 2022 when the Fed began hiking interest rates, US CRE has tumbled by 11%, erasing the gains of the two years before that. High borrowing costs, slowing economic activity, and a shift to more remote/hybrid work arrangements have resulted in a drop in investment activity and a decline in prices that are some of the steepest compared to past hiking cycles.
This led to both further tightening in CRE credit (about two-thirds of US banks have recently reported tightening in lending standards for commercial construction and land development loans), and increasing losses on CRE loans. Based on some estimates, about $2 trillion in CRE loans maturing over the next 3 years could go into distress, cause more bank failures, and induce losses of nearly $60bn, out of which $26bn from office loans. Vacancy rates on some types of commercial properties (e.g., offices) continued to rise during 2023, while values continued to decline.
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Author: Nikolay
Founder of MoneyCraft
