After a string of recent banking crises, investors are questioning the health of the commercial real estate sector.
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Concerns about the health of Europe’s commercial real estate market are mounting, with some investors wondering if this could be the next sector to implode after last month’s banking crisis.
Higher interest rates have increased the cost of borrowing and depressed valuations in the real estate sector, which has dominated in recent years amid low bond yields.
Meanwhile, the collapse of the US-based Silicon Valley Bank in March and the later emergency rescue of Credit Suisse raised fears of a so-called doom loop, in which a possible bank run could trigger a downturn in the real estate sector.
The European Central Bank earlier this month warned of “clear signs of vulnerability” in the real estate sector, citing “easing market liquidity and price corrections” as reasons for the uncertainty and calling for new restrictions on commercial real estate funds to address the risks of an illiquidity crisis.
Already in February, European funds investing directly in property saw outflows of £172m ($215.4m), according to data from Morningstar Direct – a sharp contrast to inflows of nearly £300m in January.
Analysts at Citi now expect European real estate stocks to fall 20% to 40% between 2023 and 2024 as the impact of higher interest rates begins to feel felt. In a worst-case scenario, the riskier commercial real estate sector could collapse by 50% by next year, the bank said.
“Something I wouldn’t overlook is a real estate crisis, both residential and commercial, where we’re seeing downward pressure in both the United States and Europe,” said Pierre Gramegna, executive director of the European Stability Mechanism, said Joumanna Bercetche of CNBC on Friday in Washington, DC.
An accounting for office space
The office segment — a key component of the commercial real estate market — has emerged as central to potential downturn fears amid broader shifts toward remote or hybrid work patterns in the wake of the Covid pandemic.
“People are concerned that the back-to-office hasn’t really materialized so there are too many vacancies and there is too much credit in that area as well,” Ben Emons, principal and senior portfolio strategist at US resident investment manager NewEdge Wealth told CNBC’s Squawk Box Europe last month.
People are trying to understand which banks have lent where to which sector and what the ultimate risk really is.
Ben Emons
Principal and Senior Portfolio Strategist at NewEdge Wealth
That has heightened concerns about which banks might be exposed to such risks and whether a wave of forced sales could lead to a downward spiral.
According to Goldman Sachs, commercial real estate accounts for around 25% of US banks’ loan books — a figure that jumps to as much as 65% for smaller banks that have been the focus of recent stressors. This compares to around 9% for European banks.
“I think people are trying to understand which banks have lent where to which sector and what really is the ultimate risk here,” Emons added.
Amid this uncertainty and so-called stretched valuations, Capital Economics last month raised its forecast for a peak-to-trough correction in the eurozone real estate sector to 20% from 12%, with offices expected to be the worst performer.
“We see this financial hardship, or however you want to brand it, as a catalyst for deeper revaluation than we had previously anticipated,” Kiran Raichura, deputy chief economist at Capital Economics, said in a recent webinar.
Risks in Europe less acute than in the US
However, not everyone is convinced of an impending downturn.
Pere Vinolas Serra, chief executive of Spanish real estate company Inmobiliaria Colonial and chairman of the European Public Real Estate Association, said the situation in Europe looks paradoxically strong.
Among the various factors at play, the return-to-office trend has been stronger in Europe than in the US, he said, while “turnover” or office occupancy rates have been higher on the continent.
“What’s striking is that the data shows it’s better than ever,” Vinolas told CNBC via Zoom. “There is something completely different going on in the USA than in Europe.”
European funds investing directly in property saw outflows of £172m compared to inflows of nearly £300m in January, according to Morningstar Direct data.
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According to real estate consultant JLL, the vacancy rate for offices in Europe was around 7% at the end of 2022, well below the 19% in the USA. Within the Inmobiliaria Colonial portfolio, Vinolas said current vacancy rates are even lower at 0.2% in Paris and 5% in Madrid.
“I’ve never seen that in my life. The occupancy data is at the highest level,” said Vinolas.
JPMorgan echoed that view late last month, saying in a research note that fears that a US downturn was spreading to Europe were overdone.
“Basically, we believe that contagion from US banks or US CRE (commercial real estate) to European peers is unjustified given the different industry dynamics,” analysts at the bank said.
uncertainties and opportunities ahead
Still, uncertainties remain in the sector, analysts warned.
Of particular concern is the concentration of funding by non-banks — or so-called shadow banks — which have caught the doldrums as traditional banks have been tightened, said Matthew Pointon, senior real estate economist at Capital Economics.
Before the global financial crisis, Europe’s traditional banks offered loans for 80% of the building’s value. Today they rarely go above 60%.
The challenge will be for the undemanding players who have a building that they need to customize.
Pere Vinolas Serra
Managing Director of Inmobiliaria Colonial
“A lot less is known about it [shadow banks], and they may be more vulnerable to rising interest rates, for example. So that’s an unknown that could throw a spanner in the works,” Pointon said.
Meanwhile, new EU and UK energy efficiency standards will require significant investment, particularly in older buildings, and could put some property owners under further pressure for years to come.
“I think the challenge lies with the undemanding players who have a building that they have to adapt to new requirements,” said Vinolas.
“At that level — which is a large amount, by the way — there could be huge impact, but also huge opportunity,” he added.