The sharp rise in interest rates over the last year has lowered valuations and led buyers to demand higher yields when acquiring commercial property. Banks have increased their scrutiny and caution, reducing loan-to-value funding ratios. While there is still demand from borrowers, especially for refinancing maturing debt, the amount of debt offered by banks per square metre is lower. We believe this environment presents an attractive opportunity for investors.
- The higher cost of debt is compressing building valuations across commercial sectors
- Banks have become more cautious, lending less – and at adjusted spreads
- If eurozone interest rates are near their peak, the bulk of the price reset should be behind us. If, however, inflation proves stubborn, the role of real estate as an inflation hedge will predominate, with rents linked to inflation becoming more important
- Commercial real estate has been in the headlines given reports of US office property owners defaulting on office-backed mortgage debt. This is likely weighing on investor sentiment in Europe, too. The European market is different, however, allowing Europe to avoid the severe structural and funding headwinds that confront the US market.
Outlook for growth, inflation, interest rates
Our macroeconomic research team expects the eurozone to enter a mild recession in 2023 as a result of the increase in central bank policy rates and tighter financial conditions.
While headline inflation has already peaked in the eurozone, core inflation has been stickier, but it, too, is starting to decline. We expect it to be approaching 4% year-on-year by the end of 2023.
The benchmark ECB deposit rate will likely top out at 3.75% and remain at the level through the rest of the year. Beyond the growth-dampening impact of higher interest rates, fiscal policy across the region will tighten due to a reduction in subsidies for energy.
With no more hike in policy rates ahead, we doubt commercial real estate valuations will fall much further.
Should inflation remain persistently high, we would expect the value of real estate as an inflation hedge to outweigh the impact on valuations of likely further increases in policy rates. As an asset whose cashflows (rental income) are linked contractually to the inflation rate, commercial real estate (CRE) would benefit from greater investor demand for real assets.
Real estate pricing
Currently, real estate prices are being reset (see Exhibit 1). Property markets, including those for commercial real estate, are adjusting in the face of two opposing forces:
- On one hand, the significant rise in interest rates in the eurozone since the summer of 2022 has increased borrowing costs and is weighing on property valuations
- On the other hand, higher inflation is expected to boost rental revenues over time as rents are typically partly or fully indexed to the rate of inflation.
As a result, the amount of money you can now borrow from a lender has decreased (the maximum is circa 10 points less than a year ago), while returns have increased along with market interest rates (the coupon rate on the bonds is typically floating).
Last year’s significant rise in interest rates pushed up costs for property owners. Leveraged lenders may be vulnerable when asset price resets occur. Pessimists point to the lingering effects of the Covid-19 pandemic: consumers have not fully returned to shops and many workers are still working from home. These trends are undermining the value of shopping centres and offices, though more so in the US than in the eurozone. This is because the eurozone has not seen the property market excesses that will likely create problems in the US market in coming months.
Admittedly, one segment of the European CRE market that is potentially vulnerable is lower-grade office properties. These buildings face both weakening demand and higher construction and maintenance costs. Potential buyers are retreating; lenders are imposing punitive lending rates; and occupiers are upgrading, leaving lower-grade properties and moving into buildings that meet the latest environmental standards.
Eurozone CRE should not be confused with US CRE
In Europe, highly regulated banks dominate the commercial real estate lending market, in contrast to the US. In Europe, there are more lenders, there is more equity, and banking system leverage is lower. CRE debt accounts for 9% of European banks’ loan books on average and 15% of non-performing loans. For US banks, CRE debt amounts to 25% of the loan book, rising to 65% for smaller lenders (source: Goldman Sachs).
The market is also much more conservative than it was before 2008, when lenders were offering 80% or even 100% of a building’s value in lending. This is not the case today (see Exhibit 2).
Considering these factors, we believe it is unlikely that isolated cases of asset stress in Europe will lead to a sector-wide crisis with an impact on banks.
Working from home – less of an impact in the eurozone
The shift to working from home (WFH) during the pandemic triggered discussions about the impact on demand for office space and the damage it could do to the performance of office markets. News that financial firms are encouraging, or even requiring, staff to return full time to the office suggests the trend may have peaked, but we have not yet reached a new equilibrium. If working from home expands, it could significantly reduce demand for office space, resulting in higher vacancy rates, obsolescence and falling rents.
WFH is less prevalent today in Europe. Anecdotal reports suggest offices in Europe have seen a much sharper post-COVID rebound in usage than in the US. The Wall Street Journal recently noted US office occupancy was at 40-60% of pre-COVID levels compared to 70-90% in Europe. Longer commutes, poorer public transport networks and larger suburban dwellings kept US commuters working from home. Tighter labour markets may also have led US firms to hire more remote workers in recent years.
Data from Cushman & Wakefield shows US office vacancies stood at 19% in 2022 compared to 13% in 2019. In Europe, vacancy rates in Germany increased to just 5.4% in 2022 from 4.5% in 2020. Reported occupancy rates have been remarkably stable in Europe over the last four years in contrast to the US data (see Exhibit 4).
There is also wide variation in the prevalence of working from home across Europe. For example, the share of occasional homeworkers in 2019 ranged from less than 3% in Italy to over 25% in Sweden. While the commercial real estate market will undoubtedly face challenges in the years ahead, we believe the office sector remains a viable opportunity, particularly when considering the regional differences.
Risk of stranded assets due to ESG requirements
According to the World Green Building Council, buildings account for 39% of global energy- related CO2 emissions. Around three-quarters of these emissions come from operating buildings, the rest from construction. New environmental regulations to address these issues have added significantly to the costs of upgrading a building from today’s standards to 2030 requirements.
Leading property owners with prime office space in central business districts can be expected to be able to absorb the outlays. However, owners of buildings outside city centres or in smaller towns may struggle to do so and these buildings may become stranded assets. This factor is already being integrated into the market’s assessment of buildings and contributing to lower valuations.
While the requirement to upgrade or refurbish buildings to a higher standard is a challenge for property owners, it creates opportunities for those financing it. The EU and European governments have committed to reducing CO2 emissions, which will require better construction methods and less energy consumption and wastage. The European Commission estimates that 15-30% of the European building stock will need to be upgraded or refurbished before 2030 to meet the new EU-level energy performance standards.