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Understanding the challenges in the commercial property market

Commercial property horizon

Understanding the challenges in the commercial property market

A crisis in the making? Will commercial property owners come through the looming debt repayment crisis unscathed?

The value of commercial property affects the wealth and financial stability of individuals, companies, and institutional investors, and indeed the national economy, so says the Financial Times (FT).

In the developed western economies, most private pension schemes are invested in commercial property to a greater or lesser degree, so declines in value through the economic cycle can have a dramatic effect on people’s wealth.

In the US, the European continent and the UK, commercial real estate markets, which include properties such as office buildings, retail spaces, shopping centres, industrial factories and warehouses, and multi-occupied residential units, financial pressures are being felt right now.

It’s a cyclical business affected by the general economy.

During the financial crisis in 2007-08, some prominent US investors made a killing by shorting* credit default swaps on various subprime residential and commercial mortgage-backed securities, while many property investors and owners went bust. Their exploits were portrayed in the 2015 film, The Big Short.

Almost a decade later shopping centres, suffering the effects of the growth of online sales and home deliveries were in peril, while once again shorting enabled the likes of Carl Icahn in the US to make a fortune. He shorted securities backed by US shopping malls in weaker locations, where the stores were closing one after another, leading to the securities’ debt defaults.

The third wave of shorting opportunities in the real estate markets landed with the advent of the pandemic in 2020 when the event triggered a major shift in working practices, namely to working from home (WfH). While the financial crisis shorting opportunity was mainly about residential property, the second was all about shopping centres. The Manchester based Trafford centre was a prime example.

The third opportunity came with the changes to working practices and how this affected commercial property, particularly offices in major centres.While these shorting activities – which require “nerves of steel” from their practitioners, sometimes waiting years for markets to turn – were played out mainly in the US, using what are known as “synthetic tradeable indexes”, referencing baskets of commercial mortgage-backed securities, the same overall effects were no less apparent in Europe and the UK.

With the collapse of the residential markets in 2007-08, which nearly brought down the whole financial system, the widespread defaults in shopping centres of the late teens, and the pandemic of 2020-22, meant that property, and in particular commercial property, featured right, left and centre in these crises. E-commerce hit footfall in shopping centres in the less desirable locations very hard.

This was even before the pandemic came along. The pandemic provided a further boost to home shopping, and coupled with home working, has changed peoples’ shopping and working habits since then. And these shorting bets are still on for some of the outstanding loans in the office market:

"We think there’s a lot of room for this thing to fall in the short term. And in the long term, at maturity, they’re going to be worth a lot less," one US shorting specialist told Bloomberg, as quoted by the FT.

Offices particularly hard hit

The commercial office market is facing significant and particular challenges. This is due to several factors. The primary issue is the shift to remote working, boosted by the pandemic and enabled by the same technology that enabled the take-off of e-commerce and home deliveries: a computer in almost every home, completing Bill Gates’ early 1980s dream of “a PC on every desk.”

In coming to terms with these remote work policies, many companies have successfully transitioned to a more decentralised work pattern, with a reduced need for large centralised office space.

Another factor has been the shift in Government policies aiming for net zero in 2025. In the UK, MEES regulations - Minimum Energy Efficiency Standards - are regulations that require a minimum energy efficiency in buildings to be met before properties in England and Wales can be let or sold. In many cases the implication is that commercial buildings will require substantial new investment to meet the required standards, if indeed this is possible given an existing configuration or structure.

Thirdly, full employment has to a large extent brought a big shift in the bargaining power of particularly the younger generations entering the workforce. Millennials and Gen Z workers now very often seek to work for employers that offer collaborative work environments, flexible working arrangements, proximity to amenities and high work life balance considerations. Whether this flexibility survives a major downturn remains to be seen, but the fact remains, work environments have change.

Commercial landlords need to pay attention to this shift.

A shift to more modern, tech-enabled office spaces catering to the changing needs and preferences of the new workforce is resulting in a “flight to quality”, which implies more investment in facilities and the need for smaller space generally.

The overall result of these three factors has been declining office property values. Value has declined in many locations as occupancy rates have dropped significantly. The change has led to reduced demand for traditional office space and therefore oversupply in some locations, with its consequent impact on rents and property values.

Inflation and interest rates

Particularly since the financial crisis of 2007-08 interest rates reached ultra-low levels. This had the effect of increasing asset values, in particular the value of property generally and residential property in particular. However, with a high level of government funding through the pandemic period – money printing – and supply problems in the post-pandemic period, we have seen a rapid rise in inflation across the developed nations in the West.

This has necessitated central banks increasing interest rates to heights not seen for many years.

Loans maturing

With many loans on commercial property maturing over the short to medium term, a crisis has started to appear, affecting many landlords and property funds. Morgan Stanley has said that around $45bn of commercial mortgage-backed securities would be maturing in 2023, and more in 2024 in the US alone, with office REITs accounting for around $5bn of that financing.

They have stated, as reported by the FT, that US office defaults will probably peak between 2024 and 2025, and there’s no reason to assume that Europe and the UK will be much different, with the possibility of banks experiencing risks and vulnerabilities. Those banks, many of them heavily involved in commercial real estate financing in the US and elsewhere, including providing loans for office buildings, acquisitions, construction projects, and refinancing, have high exposure to commercial property debt.

As property values have declined, loans outstanding mean that negative equity situations are almost inevitable in some cases. The amount of money involved means that non-performing loans and foreclosures in the commercial office property market is in danger of destabilising some banks and insurance companies with high exposure, depressing their capital adequacy ratios.

The UK and Europe

The UK’s commercial real estate sector is facing no less a challenge: with all the same factors behind it as in the US, increasing interest rates, even more stubborn inflation, falling property values, and liquidity issues for lenders and borrowers. All these elements have been slowly coming to a head over time.

The “slow-motion car crash” analogy has some merit here: the series of interconnected events continues to bear on the commercial property market with the same consequences for borrowers, banks and insurance companies.

Likening this to a delicate equilibrium having been disrupted, Newmanor Law, a specialist real estate legal firm, says the UK commercial real estate market finds itself “grappling with a multitude of challenges.”

The Consequences of Inactivity

“The slow-motion descent into distress poses grave consequences for all stakeholders involved,” says the firm.

“For lenders, the inability to refinance loans or recover their investments can severely impact their financial stability. If refinancing becomes unattainable, disposing of assets may be the only viable course of action.

“However, acting too late risks flooding the market with similar assets, causing a price correction that further erodes their value. Caught in a precarious situation, lenders are facing the challenge of calling the bottom of an unpredictable market.”

The owners too are facing very difficult decisions going forward. In an unfavourable borrowing environment, they will find it increasingly difficult to secure refinancing or their ability to restructure their existing debt:

“Without a proactive approach to address these issues, borrowers risk defaulting on their obligations, potentially leading to enforcement and the loss of their properties,” says Newmanor Law.

Inaction, therefore, the firm argues, will have far-reaching consequences that can spell disaster for lenders and borrowers alike. Waiting for the inevitable is not really an option. Lenders need to carefully assess their loan portfolios and identify potential problem loans ahead of time. They need to communicate openly with their borrowers and explore the options: pre-payments, injection of additional owner equity, extending repayment dates and negotiating additional security are potential ways forward.From the landlord’s perspective, owners should also assess their financial position very carefully.

Cash flow enhancement should be a priority.

Renegotiating lease terms and reducing running costs in the short term, while looking at ways to improve the attractiveness, sustainability and utility of their buildings for the future are obvious examples of this. Borrowers should be engaging in open and transparent discussions with lenders, considering loan amendments, refinancing options, subletting and even potential asset sales. Other options to consider would be partnerships and joint ventures, accessing alternative funding sources and seeking equity investors.

Newmanor Law - has a wealth of experience in this area with a focus on real estate and real estate finance, having worked across all levels of the commercial property market, for both lenders and borrowers.

*Short selling is when a stock trader borrows shares from a broker and immediately sells them with the expectation that the share price will fall. This is a risky process as losses are unlimited, but the rewards can be enormous. If it goes right for them, traders can buy the shares back at a lower price, return them to the broker and keep the difference, minus any loan interest, as profit.

Tags:

Commercial property
Interest rates
Mortgage

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