The world has a big property market problem. Australia is not immune

The International Monetary Fund last week sounded a warning of the risks to the US banking sector and financial system from rising signs of distress in the commercial property sector. The US, of course, isn’t the only property market experiencing stress.

Global property markets – from China, where that stress point is housing property development, the Asia-Pacific more broadly, including Australia, to Europe – are all under pressure from increased vacancy rates, falling values and, in the office sector that is most affected, the post-pandemic changes in the ways and locations of work.

America’s commercial property sector is the world’s largest, and it is struggling.
America’s commercial property sector is the world’s largest, and it is struggling. Credit: Bloomberg

The IMF’s blog post was focused on the US, the world’s largest commercial property market, although most of the issues it identified are, to varying degrees, echoed within most of the major markets.

“Rising delinquencies and defaults in the sector could restrict lending and trigger a vicious cycle of tighter funding conditions, falling commercial property prices and losses for financial intermediaries, with adverse spillovers to the rest of the economy,” it said.

It noted that about a quarter of the $US1.2 trillion ($1.8 trillion) of commercial real estate (CRE) debt scheduled to mature within the next two years was held by banks or was in the form of commercial mortgage-backed securities and said financial intermediaries and investors with significant exposures faced heightened asset quality risks. Smaller and regional US banks – almost five times as exposed to CRE as larger banks – were particularly vulnerable.

In Australia, the major banks and listed property trusts have relatively low exposures to the most vulnerable segment of the market, office properties. Both the banks and the A-REITs learned from their torrid experiences in the early 1990s, with the banks limiting their CRE exposures and the trusts carrying relatively low levels of both leverage and exposure.

Only about 10 per cent of office properties are owned by the A-REITs, with about 35 per cent held by unlisted trusts and foreign investors. Super funds, both the industry funds and self-managed funds, have significant exposures.

The listed trusts have a much bigger exposure to retail properties that have also been adversely impacted by the post-pandemic environment and that may have played a bigger role in the 16.5 per cent fall in the market value of the sector and the low double-digit write-downs in their valuations from their pre-pandemic levels than the issues within the office sector.

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The major driver of stress within the CRE markets has been the post-pandemic surge in interest rates globally in response to inflation rates not experienced in decades. The pandemic choked supply chains, igniting the inflationary pressures, with the US inflation rate peaking above 9 per cent and Australia’s at 7.8 per cent.

The increased interest rates and the cost of servicing their debt lowered yields from CRE assets and reduced their value, with the dramatic shift to remote working during – and post – the pandemic adding another layer of downward pressure on office property valuations. A big increase in e-commerce activity – a long-term trend accelerated by the pandemic – has had a similarly structural impact on retail properties.

In the US there is about $US4.6 trillion of CRE debt. Delinquency rates have been rising, albeit that they remain quite modest at about 2.3 per cent. Office property delinquencies and late payments have also been rising and are more significant, reaching 6.5 per cent in the December quarter.

Our national office vacancy rate, according to JLL Australia, is rising and reached 14.9 per cent in the December quarter.
Our national office vacancy rate, according to JLL Australia, is rising and reached 14.9 per cent in the December quarter.Credit: Getty Images

The risk in the US from a continuing deterioration in CRE-related property lending is that most of that lending is undertaken by regional and small banks and CRE loans represent a big slice – nearly 30 per cent on average – of their total assets.

The regional banking crisis last year, sparked by the impact of rising interest rates on their bond holdings rather than their loan exposures, underscored how vulnerable the smaller banks are.

The National Bureau of Economic Research think tank in the US has estimated that as much as 20 per cent of CRE loans could default, causing losses of $US160 billion and putting nearly 70 banks with nearly $US30 billion of assets at risk of insolvency.

The NBER also said that about 14 per cent of all loans and 44 per cent of office loans appeared to have negative equity – the value of the properties was less than the value of the loan.

The chief executive of the big US securities firm, Cantor Fitzgerald, Howard Lutnick, speaking at the Davos World Economic Forum earlier this month, said that he thinks commercial property defaults over the next 18 months to two years could amount to between $US70 billion and $US1 trillion as a “general shift” occurred in the CRE market.

The nature of both property ending and property leasing creates lags. It takes quite some time for property loans to mature and leases to expire.

It is likely, therefore, that the worst of the property market stresses are yet to be visible, although the halving of property market activity in the US from pre-pandemic times, office vacancy rates of up to 20 per cent and falls of as much as 40 per cent in office property values in some major cities provide some insight into the current degree of distress.

The major driver of stress within the CRE markets has been the post-pandemic surge in interest rates globally in response to inflation rates not experienced in decades.

The Australian outlook appears less dire than the scenarios envisaged by the NBER and other US analyses, given the relatively conservative approach of the major banks and listed investment vehicles.

There is a consensus that the post-pandemic settings will have much less impact on A-grade properties and on owners with the capacity, like the A-REITS or major super funds, to upgrade and reconfigure their properties to adapt to the demand for smaller but higher-quality office spaces as employers try to encourage workers to return to their offices than they will on lesser-quality properties.

The national office vacancy rate, according to JLL Australia, is rising and reached 14.9 per cent in the December quarter but most of those vacancies are concentrated – as is the case in the US and elsewhere – on B-grade assets.

In Europe, the European Central Bank last year warned that bank exposures to CRE could threaten European financial stability if economic conditions deteriorated, amplifying an adverse scenario and increasing the likelihood of systemically-relevant losses, although only about 10 per cent of eurozone bank loans are exposed to CRE.

Activity levels and prices in the major European markets have, like markets elsewhere, plunged – in France CRE investment was more than 60 per cent lower in 2023 and, in Paris, the lowest volume of activity in the capital since the global financial crisis.

Interest rates in most of the major economies appear to have peaked, with inflation rates falling back significantly. There should be interest rate cuts in most of those economies at some point this year.

That will eventually flow through to lower borrowing costs for CRE investors but won’t come quickly or significantly enough to relieve the near-term stresses or the stressed valuations and won’t address the structural challenges that the changed work practices and environments pose.

In any event, it is improbable that the pre-pandemic settings of negligible to negative real interest rates that greatly inflated the value of all investible assets, including CRE, will return unless there is another financial crisis. The next few years are going to be difficult ones for lesser-quality CRE assets and those who own and have funded them.

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Source: Thanks smh.com