Banks have had a tricky time lately. There have been signs of stress in the sector since March, and regulatory changes are likely to affect their lending criteria in the future. This will have an impact on real estate.
Even before the collapse of Silicon Valley Bank (SVB) in the US, there were already challenges confronting the commercial real estate (CRE) market.
- Higher borrowing costs have put pressure on debt services;
- A slowing global economy has weighed on the earnings outlook for occupiers. This is combined with inflation (including borrowing costs), squeezed profit margins and tenants’ ability to pay rents;
- Long-term structural changes are challenging the fundamentals of retail and office properties. The migration towards online shopping, flexible working arrangements, and the accelerated obsolescence of existing office stock (as a result of higher sustainability targets) are having an impact.
Reduced lending capacity affects real estate
The recent turmoil in the global banking sector has reinforced some of these challenges. In the near term, it appears the worst of the banking sector stress is behind us, but regulators are likely to curtail banks’ lending capacity. This was evident in the hearing with the US Senate Banking Committee in late-March, even though the form of these regulatory changes remains unclear. Tighter lending regulations will put more pressure on CRE valuations, especially in the US where regional banks have been an important funding source.Lending regulations could widen funding gaps
The US CRE market appears to be more vulnerable, compared with its European and Asia-Pacific peers. Even before the prospect of tighter lending regulations, CRE lenders were already becoming more cautious in the US. Commercial property in the US is facing funding gaps because of falling valuations and lower loan-to-value (LTV) ratios being granted by lenders. CBRE Econometric Advisers (EA) estimates that at the beginning of March (pre-SVB) office owners faced a financing gap of USD73 billion (bn) in 2023-25. Importantly, CBRE EA noted that this gap was heavily concentrated in the office sector. This differentiates the current funding issues from the Global Financial Crisis (GFC), when large funding gaps were prevalent across all major sectors. The current challenges have resulted in even high-profile institutions and good assets experiencing difficulties in refinancing, especially in the office sector. The prospect of tighter lending regulations, especially for regional banks, and the dislocation in the commercial mortgage-backed securities (CMBS) market will exacerbate the problem. European banks’ share of CRE lending has been on a steady decline since the GFC. That share has more room to fall, though, given Basel III capital requirements. Investors’ appetite for additional Tier 1 bonds from banks has also reduced. While most observers deem the European CRE market to be less vulnerable compared with the US, many challenges remain. The default on a CMBS loan backed by secondary Finnish offices in early March (again, pre-SVB) highlighted that lenders are increasingly reluctant to grant extensions to loans with impaired fundamentals – even if the sponsor is a high-profile institution. Indeed, it appears the CRE market in the Nordics (in particular, Sweden) could be more vulnerable in the near term, given their refinancing needs and potential funding gaps.Opportunities for patient investors
The more cautious lending environment, coupled with near-term refinancing needs, will likely result in more distress in the CRE market. This is especially the case for office and retail assets in the US and some European markets. But for investors with capital to deploy, this should present interesting entry points for investment. These include:
- CRE lendingAs banks and other funding sources pull back, we expect non-bank lenders to capitalise on the lower levels of competition to secure more attractive deals (lower LTVs backed by better-quality assets at higher margins). Consequently, our CRE lending team is seeing strong interest from investors in strategies that are targeting investment-grade senior loans in the UK.
- Office value-add strategiesDespite the current sentiment towards offices, we expect occupier demand to be increasingly concentrated in higher-quality space that meets sustainability targets. Indiscriminate selling of offices could present secondary-grade assets in core locations that are ripe for intervention at attractive entry prices.
- Sale-and-leasebackTighter lending conditions will allow core investors with available cash to provide a platform for capital-constrained business owners to monetise their assets at more attractive yields. We think the investment case is especially robust if this involves assets, such as industrial facilities, on very long-term triple-net lease, with embedded rent increases.
Investors should not just focus on the negative news that can so easily dominate headlines. As important as the news may be, it is equally important to keep focused on the valuable opportunities that the banking pressures can present.