What does the future hold for Commercial Real Estate (CRE)?

The post-pandemic world presents a variety of challenges for businesses. In particular, owners and financiers of Commercial Real Estate (CRE) have faced a confluence of negative impacts. The advent of remote working has reduced the dependency on office space. Hybrid working means that few visit the office five days a week, with 24% of employees either continuing to work from home or unable to work due to Covid-related illness.

In addition, tighter monetary conditions and rising interest rates have weakened consumer demand and raised refinancing costs; a double whammy for businesses facing declining sales growth and rising rent costs. The turmoil in the banking sector in recent weeks has refocused investor attention on counterparty risk. As debt financing costs rise, the risk that owners of commercial property default on their loans increases.

Tighter lending conditions and higher interest rates have already heavily impacted borrowing activity. The CRBE Lending Momentum Index, which tracks commercial real estate loan closings in the US, fell by 27% year-over-year in Q4 2022. However, over 80% of bank loans issued were floating-rate loans, leaving borrowers exposed to rising interest payments following further rate hikes by the Federal Reserve.

European banks are also exposed to these pressures, with CRE exposure of roughly 8% of total loan books on average. Swedish banking institutions are of particular concern, as inflation in Sweden remains sticky at 12%, and the Riksbank faces pressure to further hike interest rates.

Rapidly tightening monetary conditions inevitably causes fractures in the financial system. Conditions in commercial real estate markets are likely to worsen further before they improve, but whether individual business failures have the potential to kickstart a systemic crisis remains uncertain.

Adam Fisher, Investment Analyst