The Changing Landscape of Commercial Real Estate Investments

Commercial real estate investors and lenders face uncertain future amid changing work and shopping habits

Commercial real estate investors and lenders are grappling with a challenging question: If post-pandemic work and shopping habits continue, how secure are the investments made in physical properties like malls and office buildings? The sector is facing rising interest rates, persistent inflation, and economic uncertainties, raising concerns among experienced buyers who are accustomed to riding out downturns until rental demand bounces back and borrowing costs decrease.

However, analysts, academics, and investors now believe that this time could be different. With remote work becoming the norm for many office-based companies and consumers increasingly embracing online shopping, major cities like London, Los Angeles, and New York are witnessing a surplus of buildings that no longer cater to local needs or preferences.

The prolonged recovery of values in city-center skyscrapers and sprawling malls is anticipated, and if tenants remain scarce, landlords and lenders may face more severe losses than in previous cycles.

Richard Murphy, a political economist and accounting professor at the UK’s Sheffield University, expressed concern, stating, “Employers are beginning to appreciate that building giant facilities to warehouse their people is no longer necessary…Commercial landlords should be worried. Investors would be wise to quit now.”

The situation is further complicated by the substantial amount of commercial real estate debt held by global banks, with the largest share set to mature between 2023 and 2026. US banks have reported increasing losses from properties in their first-half figures, signaling the likelihood of more to come.

Lenders providing credit risk assessments for US industrial and office real estate investment trusts (REITs) have revealed a 17.9% increase in the likelihood of defaulting on debt compared to estimates six months ago. UK real estate holding and development borrowers also face a 4% higher risk of default.

Jeffrey Sherman, deputy chief investment officer at the $92 billion US investment firm DoubleLine, warned of potential deposit flight from banks due to higher rates, a ticking time bomb that could affect the commercial property refinancings due in the next two years.

Despite these concerns, some policymakers believe that the shift in work dynamics post-pandemic may not lead to a 2008-2009-style credit crisis. Demand for loans from eurozone companies has hit record lows, and the US Federal Reserve’s stress tests found banks to be relatively resilient to an extreme scenario of a 40% drop in commercial real estate values.

Average UK commercial property values have already declined by about 20% without triggering significant loan impairments, and the proportion of property exposure in UK banks’ overall lending has decreased since 15 years ago.

However, Charles-Henry Monchau, chief investment officer at Bank Syz, compared aggressive rate tightening to dynamite fishing, suggesting that it might reveal the true extent of the crisis only after some time.

Global property services firm Jones Lang LaSalle has reported negative prime office rental growth in major cities such as New York, Beijing, San Francisco, Tokyo, and Washington. Office vacancy rates in Shanghai rose to 16%, indicating a recovery dependent on successful nationwide stimulus policies.

As businesses seek to reduce their carbon footprint, companies like HSBC are cutting rental space and terminating leases at offices deemed insufficiently eco-friendly. Experts predict that over one billion square meters of office space worldwide will require retrofitting by 2050 to meet net-zero targets, putting pressure on the real estate market.

In light of these challenges, Australia’s largest pension fund, AustralianSuper, has suspended new investments in unlisted office and retail assets due to poor returns.

Short-sellers are also circling listed property landlords globally, betting on a further decline in stock prices. Capital Economics forecasts global property returns of around 4% annually this decade, compared to the pre-pandemic average of 8%, with only a marginal improvement anticipated in the 2030s. As a result, investors must be prepared to accept a lower property risk premium, as property valuations seem overvalued by past standards.