Morgan Stanley says commercial real estate will crash harder than during the Great Financial Crisis. Here’s how 5 other great institutions see things unfolding

Major banks, research and advisory firms weigh in on the state of the commercial property sector, with forecasts and assessments ranging from a price drop ‘worse than during the Great Financial Crisis’ to challenges “manageable”, in an environment of high interest rates and the credit crunch which have both raised the cost of borrowing and seen defaults increase.

There seems to be a consensus that the office sector is most at risk, given the widespread shift to working from home that has emerged from the pandemic, which has largely impacted demand. How this will affect the overall market, however, depends on who you ask.

To better understand what could happen next for commercial real estate, let’s take a look at recent articles from Capital Economics, PwC, Morgan Stanley, Bank of America, UBS and Goldman Sachs.

In a report by Kiran Raichura, deputy chief real estate economist at Capital Economics, he compares the beleaguered office sector to shopping malls, which he says have seen no real recovery. Both sectors lack demand, and in the case of offices, it is because of the shift to working from home.

The research firm suggests that “the 35% drop in office values ​​we project by the end of 2025 is unlikely to be recovered even by 2040”, meaning office values ​​are unlikely to recover their pre-pandemic peaks over the next 17 years. years.

The reasoning of the company? Office key card swipes have fallen to 50% of pre-pandemic levels (which were already 70% to 75%). This low utilization is pushing businesses to reduce their physical space, which equates to a higher vacancy rate of 19% in the first quarter of this year compared to 16.8% in the last quarter of 2019. Still, says Raichura, the real increase is about double when taking into account the vacancy of sublets. Thus, office vacancy has already increased more significantly than that of shopping centers between 2016 and 2023.

Additionally, major landlords are already returning their escrow office assets to lenders, which will likely increase following an increase in commercial mortgage-backed securities defaults seen in May, according to the company. All the while, investors in real estate investment trusts are “avoiding functions.” After more than three years of downturn, the office REIT total return index is down more than 50% against the all-equity REIT index, similar to the drop in the yield index totals of regional shopping center REITs in the early years of the retail sector. correction, stresses Capital Economics.

All this to say that the road ahead for office owners “will be tough”, as Raichura put it, without addressing the general state of commercial real estate.

In PwC’s mid-year outlook, the professional services firm simply said that commercial real estate is not collapsing. Despite Federal Reserve interest rate hikes that have pushed up the cost of borrowing and a pandemic that has changed the way people work, PwC says there are still opportunities for deals ahead.

“We believe the sector is not in crisis, as successful traders will find opportunities, with green shoots evident in all sub-sectors, including the much maligned office sub-sector,” PwC noted.

That being said, transaction volumes declined across all commercial real estate sub-sectors in the first quarter of this year compared to the same period last year. Office was down 68%, hospitality was down 55% and industrial was down 54%, according to the report. Nonetheless, PwC expects leasing activity and deal flow to pick up as interest rates and economic policy improve. But for now, the sector will continue to face headwinds and dealmakers may need to get creative.

“Commercial real estate assets face multiple challenges amid higher interest rates and reduced appetite for bank lending in the space,” PwC said. “The rising cost of debt is forcing dealmakers to take longer to assess the right debt/equity mix to fund deals and has protracted negotiations as buyers and sellers slowly align with market expectations. valuation.”

Lisa Shalett, chief investment officer of Morgan Stanley Wealth Management, sees a ‘huge hurdle’ ahead of commercial real estate, and particularly office buildings which have seen rising vacancy rates and falling property values ​​since then. the pandemic. Meanwhile, the industry as a whole faces a flurry of upcoming loan maturities, likely amid tighter lending standards. This is likely to lead to increased chargebacks and defaults and lower property values, which Shalett echoes in his assessment.

“More than 50% of the $2.9 trillion in commercial mortgages will need to be renegotiated over the next 24 months, when new lending rates are expected to increase by 350 to 450 basis points,” Shalett wrote. For these reasons, Shalett and the bank’s analysts “expect a drop in CRE prices of up to 40%, worse than during the Great Financial Crisis.”

Shalett also suggests that no industry will be “immune” from the fallout that will occur from these expected defaults and defaults that would go beyond landlords and banks.

Bank of America analysts have repeatedly pointed out that the challenges ahead for commercial real estate are manageable, citing a few reasons. But first, let’s look at what Bank of America suggests are the two main challenges ahead. The first: high inflation that caused the Federal Reserve to raise interest rates, making it much more expensive to service new and maturing commercial real estate mortgage debt. The second: remote work, which has proven to extend beyond the pandemic and has greatly diminished demand.

“We conclude that the challenges are real and significant, but for several reasons they are manageable and do not represent a systemic risk to the U.S. economy,” the Bank of America analysts wrote.

So what are some of these reasons? First, there are financing tactics that commercial real estate borrowers can use to avoid defaulting on their debt, such as loan modifications and extensions. As a result, the 17% of loans that analysts say mature this year can be refinanced using tactics that could protect distressed borrowers from higher costs in the current economic environment. Second, Bank of America analysts say office buildings account for 23% of commercial real estate loans maturing this year, but that’s only 3.8% of all commercial real estate. Finally, the improvement in underwriting following the Great Financial Crisis makes loans less risky. In two trends observed by analysts at Bank of America, they found that debt-to-service coverage ratios are significantly higher and loan-to-value ratios are significantly lower, signaling a change from underwriting. forgiving pre-GFC.

Analysts at UBS, the Zurich-based multinational investment bank, say “the headlines are worse than reality”, and a repeat of the 2008 liquidity crisis is unlikely. In their less dire tone, analysts say about $1.2 trillion of the $5.4 trillion in commercial real estate debt (excluding multifamily) is expected to mature, likely at higher rates. Yet this should add to existing challenges in the office sector (which they say accounts for 15% of total CRE value), rather than posing systemic risk. But it does mean office owners could be more likely to default on their debt.

“About $1.3 billion in office mortgages are expected to mature over the next three years,” the analysts wrote. “Some of these loans may need to be restructured, but the scale of the problem pales in comparison to the more than $2 trillion in bank capital. Office exposure for banks represents less than 5% of total loans and only 1.9% on average for large banks.

Despite their optimism, things can still get worse, especially in the event of a severe recession.

“While we view the potential losses as manageable, we would expect a significant deterioration in CRE to put pressure on bank stocks due to both earnings and profitability risk,” the analysts wrote.

Goldman Sachs analysts turned directly to the office sector, which they said “has been the subject of significant investor attention in recent months, and rightfully so, in our view.”

While analysts suggest multifamily and industrial properties have remained resilient, they pointed to three risks to the sector. First, analysts said CRE borrowers are exposed to higher rates, which equates to higher costs and increased exposure to floating rate liabilities. This brings us to the second risk: refinancing could be painful. Their estimate is that $1.07 trillion in commercial mortgages will mature before the end of 2024.

This means that “many borrowers will likely need to refinance their fixed rate loans at higher rates,” the analysts wrote. For distressed office property owners, the ability and willingness to refinance at a higher rate will be limited. Finally, Goldman Sachs analysts suggest that financing conditions will tighten further in the future. However, unlike others, analysts did not explicitly blame bank failures. Instead, they highlighted the role banks play in commercial real estate transactions.

“The potential for disruptions to commercial real estate activity in the United States due to a decline in the availability of credit from smaller banks is significant, unaided by the fact that the segments most dependent on bank financing – offices and retail businesses – also face the highest risk of functional obsolescence,” the analysts wrote.

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