A view from London

The last four years have been difficult for the commercial real estate (CRE) sector. The pandemic, high interest rates and the shift to home working have weighed on the value of commercial property, a broad sector that includes offices, retail, industrial and warehousing. Last year alone global CRE values fell by 12%, according to the IMF. The brunt of the adjustment has been born by offices, where values fell 19% worldwide last year. In the US the decline was even greater, with office values declining 23%.

The IMF draws on data from institutional investors. An alternative approach is to track the price of listed real estate investment trusts (REITs) though these also provide an incomplete picture since significant amounts of property are privately held. The S&P index for a portfolio of UK REITs, covering all commercial property categories, shows prices have fallen by about 35% since 2020.

Like the assets themselves, ups and downs in commercial property prices are highly product and region-specific.

Office prices in western countries, where working from home has taken off, have seen some of the largest declines. The S&P office REIT indices for the US and UK have almost halved in value since 2020. Home working and higher interest rates are the proximate cause of the sector’s problems, but in a number of countries, including the UK, landlords also need to meet the cost of upgrading older buildings to meet energy efficiency standards.

Nonetheless, the story varies within the office sector. Pricing and demand remain strong for prime office buildings.

The value of industrial and warehouse property surged in the early stages of the pandemic, bolstered by demand for manufactured goods and a surge in home shopping. Those trends went into reverse from early 2022, with manufacturing activity slowing and consumers switching back to in-store shopping. Last week Sainsbury’s reported that in-store demand was close to normal levels. These trends have contributed to the near halving of the value of UK warehouse and industrial property REITs since early 2022.

CRE, and in particular, office property, has been under pressure across much of Europe and North America. Falling real estate values have created losses for investors, including banks, prompting increased scrutiny from regulators. The nightmare scenario is of a wave of loan losses forcing banks and other lenders to withdraw credit from the rest of the economy leading to a 2009-style credit crunch.  

Such an extreme outcome is unlikely, but there are growing signs that CRE losses are feeding through into the financial system.  

Shares in banks with particular exposure to real estate have seen their shares fall as losses on loans have come through (they include Deutsche Pfandbriefbank, a German lender with exposure to offices and New York Community Bank, a lender with 60% of its assets tied to Manhattan commercial property).

The risks appear more acute in the US, where major banks have twice the exposure to commercial property as their European peers. The National Bureau of Economic Research estimates that 44% of US office loans are on property where the current valuation is less than the underlying debt. Several US REITs have paused redemptions, suspending the ability of investors to recover money, to preserve liquidity. 

Adding to the sector’s problems, rising interest rates have reduced the availability of capital for property investment from banks, private equity and market-based sources. US issuance of commercial mortgage-backed securities (CMBS) in 2023 was almost half the levels seen in 2022. It is a measure of the strains in the system that delinquencies of CMBS specialising in offices reached 6.1% in 2023, a four-fold rise from a year earlier.

The problem is real, but the chances of it turning into a full-scale financial crisis are low. CRE is a relatively small asset class, a subset of a much larger property sector, one that includes residential housing and farmland where prices have held up relatively well. (The Case-Shiller index shows US house prices have risen 46% since early 2020; UK house prices have risen 20% over the same period on the Halifax measure.)

Hard data are thin on the ground, but using plausible assumptions we think that CRE might account for roughly 12% of the global stock of property including housing and farmland. The risks are greatest in the office sector, which accounts for perhaps one-third of CRE and, therefore 4% of the global property market.

The Economist estimates that even if the value of all US office real estate fell to zero – a doomsday outcome – the losses would be just a quarter of the value destruction during the residential property price crash between 2007–09.

Lower real estate prices are not usually sufficient to cause a loan default. The risks are higher when a large proportion of a landlord’s leases roll over, or when their office loan is maturing, or both. But commercial property loans typically have long maturities, averaging around 15 years, meaning the impact of leases rolling over or maturing is spread over time.

Lenders are also better placed to cope with loan losses than in the past. Banks are better capitalised and leverage is lower. In contrast to the blow up in the opaque world of derivatives during the financial crisis, the problems of the office market are well documented and regulators are alive to the risks.

Even in the US, where a major round of real estate refinancing is due this year, there are some positives. Growth in the US has far outpaced other major western economies and is likely to do so again this year. Continued growth, along with the possibility of interest rate reductions later this year, should help support the US CRE sector.

There are some signs too of a gradual drift back to the office. European office occupancy rates are way below the 70% level seen before the pandemic, but have risen from 55% to 59% over the last 12 months, according to Savills.

The CRE sector, and particularly offices, have been hit by the fallout from the pandemic and a period of high interest rates. The resulting loan losses have put pressure on parts of the financial system and prompted heightened scrutiny from regulators. But given the sector’s relatively small size and the strength of the wider financial system the problem looks manageable.