Commercial real estate concerns mount after SVB, Credit Suisse
After the failure of Silicon Valley Bank (SVB) and the distressed sale of Credit Suisse to UBS, investors are naturally looking for what may be the next shoe to drop. Comments by institutional and family office investors point to commercial real estate markets as an area of mounting concern.
In particular, worries over office real estate are driving growing anxiety. With bank lending expected to tighten, pain could spread across commercial real estate debt, particularly loans backed by office buildings.
The pandemic and resultant change in working practices, particularly for big firms, has changed the face of commercial offices, perhaps forever, according to Hong Kong-based family office investor Timothy Tsui.
“The glut of empty commercial real estate and offices is a big risk that people are sweeping under the rug, for now," Tsui told AsianInvestor.
"What's going to happen to those funds that invested in these giant office blocks, like Canary Wharf in London? We’ve seen HSBC announcing to the world that they are going to reduce their office demand by half in Canary Wharf. That’s just one example.”
The revenue modelling, based on that bank's ownership was 60-80% occupancy, said Tsui. "Now you’re hitting 60% and you’re faced with higher interest rates. So, who’s going to pick up the shortfall?
"This is obviously not something people want to talk about, because it’s a reality that a lot of commercial real estate investors cannot face. And of course, not everyone is a 100% cash buyer, so they have loans tied to this. If occupancy continues to hover around 60-65% and rentals start dropping, with high interest rates you have a double whammy. It’s going to be very painful.”
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Major banks including JP Morgan, Bank of America and Goldman Sachs have all issued warnings this week that the banking sector crisis has consequences for the commercial real estate market.
Goldman noted in a circular that the commercial real estate sector has half of the $5.6 trillion of outstanding commercial loans is sitting on bank balance sheets, meaning that bank lending remains the primary source of funding for the sector. “This is particularly the case for small banks which capture the lion’s share of lending,” it said.
Singapore-based family office investor Edward Foo told AsianInvestor he believes well-managed real estate-heavy funds will be well placed to ride out the storm.
“They will even benefit from special situations and distressed opportunities. This will probably account for under 25% of funds in the real estate space, though. The rest will twist in the wind. Keep in mind that commercial real estate assets are less liquid today than they were in 2019 and there are only a handful of funds with access to very low weighted average cost of capital."
David Ellis, Hong Kong-based partner at law firm Mayer Brown, told AsianInvestor a potential market downturn typically gives birth to "a pair of awkward twins. On the one hand increased opportunities for new investment, as high interest rates can force the hand of sellers. On the other hand, a drop in valuations of the current portfolio, making it harder to raise new money”.
Foo agrees with Tsui that there are many mid-sized real estate funds and REITS that may be over-leveraged. “And there are private equity and private debt funds that have exposures to real estate indirectly, through bilateral debt deals with owners. Those are not configured to ride out the storm.”
Ellis added, “We are not seeing much signs of distress yet, but after such a sharp interest rate hike, it would not be surprising if we saw more of it”.
Although the Federal Reserve is considering further interest rate rises to curb inflation, the banking crisis has also, in effect, led to a natural tightening of financial market and credit conditions, potentially removing the need for more aggressive rate hikes.
Josh Scoville, senior managing director at US real estate manager Hines, says investors should remain calm because the underlying economic situation is not so bad.
“There are many things to worry about, including the length and severity of Ukraine’s crisis, but rising short-term rates have historically coincided with much stronger real estate performance, so don’t put the Fed ’s tightening cycle high on your list of worries. It’s not on mine.”