Swiss Re Institute: US CRE Will See Rough Sledding for Years

Many recent studies and analyses on commercial real estate have been delivering negative news: rent growth down, valuations down, financial pressures up, and some sectors like office facing potential graver news. Like this is news to those in the industry.

Swiss Re Institute, which produces research from data and risk knowledge that the reinsurer Swiss Re has through its operations, has a new take on U.S. commercial real estate: “expecting prolonged challenges.” That is, corrections will last “several years.”

The good news: pressures are unlikely to pose systemic risks. The not-so-good news is that “structural and secular declines” in CRE “will contribute to the fragility and weakening of the U.S. economy.” A logical deduction is the possibility of vicious circle, where the economy hurts CRE, which then further hurts the economy.

“The office sector faces the most stress, with increasing credit default risk, a difficult refinancing environment, and reduced appetite for additional equity investments,” the firm said. “While also vulnerable, higher quality CRE exposures for insurers should aid in mitigating downside risk, relative to other investors.”

One of the conditions the analysis considers is the now debunked assumption made popular by some large financial institutions that small banks originate 80% of CRE bank loans. According to Moody’s Analytics, banks hold only 38.6% of CRE lending, with the 829 community banks with $1 billion to $10 billion in assets responsible for a total of not quite a quarter of that. The 25 largest banks have a little under a third of the total bank portion. While banks are facing stressors to stability and liquidity, they aren’t holding a majority of CRE loans.

“Looking forward, we see a multi-year downturn in the office space, driven by entrenched structural changes in the post-pandemic economy,” Swiss Re wrote. “This will pressure both small banks and insurers, but the challenges will likely be more pronounced for the former, and they are unlikely to pose systemic threats to financial stability.”

While office has faced a record high 18.2% vacancy rate in the fourth quarter of 2022, these are from shifts in how companies operate, including work-from-home trends. The full effects long-run are yet to be known, but as a number of different observers have noted, if directions move toward hybrid with a certain number of days with everyone expected in the office, then it might be difficult for most companies to cut too much of their real estate leases because space will be needed for those surge times.

“The retail segment (18%) struggled long before the pandemic due to structural changes tied to the e-commerce boom,” they wrote. “Retail will continue to face long-term, but not new, cash-flow and geographic pressures. In contrast, the industrial segment (20%) has actually benefitted from the pandemic-driven surge in goods demand. In Europe, meanwhile, office demand is relatively stronger than the US. The average vacancy rate is less than 8%, while leasing activity rose 14% year-on-year in 2022 and office take-up rose 2% above the pre-pandemic average.”

While there will be “moderate increases in defaults” in their analysis, workouts will be long. Lender will pursue loan modifications like loan-to-value ratios of 50% to 55% and more conservative debt-service coverage ratios.

“Any further liquidity stresses faced by banks or a deeper US recession would also pressure CRE valuations,” they continued. “While loan losses will depend heavily on the transaction, average loan-to-value ratios imply a 40-50% decline in values before losses are taken.”