Looking for a solid ground

High rates and potential delinquencies have resulted in subdued investments

The global commercial real estate (CRE) market is at a crossroads after being battered by pandemic disruptions and recent upheavals. A turning point looms, demanding critical reflection and strategic pivots as firms adapt to hybrid work culture, geopolitical concerns and volatile markets. The next 12-18 months will be decisive for repositioning, potentially requiring firms to restructure their property portfolios to identify a solid ground as they navigate the evolving landscape of real estate investments.

In our previous article titled ‘US commercial real estate lending’, we highlighted the sector's struggles in 2023. Soaring interest rates have dampened loan demand, casting a shadow. This trend is poised to continue, with the impending debt cliff of $2.81¹ trillion maturing between 2024 and 2028, raising concerns over refinancing risks. Global CRE investments plummeted in 2023 - 37% on-year to $157 billion in the fourth quarter² and 47% on-year to $647 billion³ for the full year. The drop was across regions, with the Americas declining 50%, Europe 46% and the Asia-Pacific 29% for the full year.

Past disruptions have set the stage for repricing valuations. With the United States (US) leading the way and Europe and Asia-Pacific poised to follow, we expect price adjustments across sectors and markets to be uneven. Office pricing and liquidity are under pressure, reflecting weak global sentiment among investors and lenders. The residential sector has maintained its lead, but fundamentals are subdued and approaching the long-term average.

Although delinquencies haven’t reached the Global Financial Crisis (GFC) highs of 8.9%⁴ seen in the first quarter of 2010, the global CRE landscape seems precariously placed. It is navigating negative returns, high leverage and limited refinancing options.

The high rates, low valuations double whammy

When will the pressure ease? Real estate valuations are unlikely to stabilise across most property types until mid-2024. Excluding office assets, cap rates rose ~150⁵ basis points (bps) between early 2022 and late 2023, varying by market and asset type. The rise was even more pronounced in the office sector, with cap rates exceeding 200 bps, translating into a potential 20% decline in the value of most property types.

CBRE anticipates a further 25 to 50 bps expansion in cap rates through 2024, resulting in values potentially declining another 5-15%.

Can the market weather the delinquency storm?

Almost one-half of US banks hold CRE as the largest loan exposure, while one-quarter of them have large CRE loans relative to their capital levels⁶ (European⁷ banks’ CRE exposure is limited to ~10%).

CRE loan delinquencies have been increasing since the fourth quarter of 2022 in the US. They rose 60 bps to 1.39%⁸ as of December 2023, surpassing the five-year high of 1.02% attained during the pandemic-hit fourth quarter of 2020; this indicates a high probability of default or deterioration in collateral value. The delinquency rate for office loans rose to 6.5%⁹ in the fourth quarter of 2023, topping the hotel delinquency rate of 6.1% since the pre-pandemic period.

Given this scenario, regulators fear the interconnectedness between financial intermediaries - including banks, insurance companies, real estate investment trusts and private lenders - could have a domino effect and exacerbate stress. 

Mounting pressure amid rising scrutiny and rating actions

The Securities and Exchange Commission has recently asked four¹⁰ banks - MainStreet Bancshares Inc. (43.1% of the portfolio comprised CRE loans as on December 31, 2023), Mid Penn Bancorp Inc. (41.9%), Alerus Financial Corp. (30.4%) and Ohio Valley Banc Corp. (19.3%) - to monitor and provide detailed disclosure on their CRE portfolios, given higher exposure than the entire US banking industry (14.6%).

Until 3Q23, S&P¹¹ had lowered ratings on nine US banks, revised outlooks on five banks to negative and on four banks to stable from positive amidst rising earnings pressure, subdued loan growth as economic activity slows and deteriorating asset quality. On 26 Mar 2024, S&P¹² downgraded outlook on five regional US banks to negative from stable, due to their weakening CRE exposures. CRE is likely to be the biggest driver of a general worsening in asset quality. Banks have tightened lending standards (loan to value, debt service coverage) across most loan types, especially for non-prime borrowers. Banks have limited share repurchases to build capital and strengthen their balance sheets.

Mixed signals, cautious hope

The path to recovery for the CRE market is challenging and relies on several factors, from the macroeconomic environment to global events to the evolving post-pandemic work landscape.

The industry will need to confront oversupply in certain sectors and adjust to changing consumer preferences that may drive up the vacancy rates, which could, in turn, lead to higher delinquency rates. Adaptability and focus on tenant needs will be crucial for navigating potential disruptions and seizing profitable opportunities.

But the news is not all gloomy. While the office sector could struggle long-term owing to secular changes in work arrangements, office loans represent less than one-quarter of total CRE loans in median rated banks. Furthermore, despite the acceleration in CRE delinquencies, banks’ broadly diversified loan portfolios and conservative underwriting are expected to mitigate losses.

The bulk of loans maturing in the next couple of years originated during 2013-2018, when the loan-to-value ratio was conservative (~5% lower than in the five years before the GFC), and hence provides a cushion. Moreover, banks are better capitalised and have access to credit facilities that can offset temporary liquidity issues. As such, closely monitoring emerging trends, prioritising risk mitigation and regulatory compliance could be critical to stem contagion. 

¹ CRE Mortgage Maturities & Debt Outstanding: $2.81 Trillion Coming Due by 2028
² CBRE Global investment activity stays subdued in q4 2023
³ JLL Global Real Estate Perspective highlights, November 2023
⁴ Fred Economic Data
⁵ CBRE US real estate market outlook 2024
⁶ Financial Stability Oversight Council Annual Report 2023
⁷ ECB Real estate markets in an environment of high financing costs
⁸ S&P Market Intelligence CRE loan delinquencies increase YOY
⁹ MBA Delinquency Rates for Commercial Properties
¹⁰ SEC eyes commercial real estate exposure, questions 4 banks
¹¹ Capitaliq Research Document
¹² S&P Global downgrades outlooks on five regional US banks to 'negative'