Commercial Real Estate at a crossroads
(MENAFN – Caribbean News Global)
(PHOTO: ANDIPANTZ FROM GETTY IMAGES)
By Andrea Deghi and Fabio Natalucci
Empty office building. Reduced opening times. Incredibly low hotel room rates. All are signs of the times. The containment measures put in place last year in response to the pandemic of closed shops and offices have severely impacted demand for commercial property – particularly in the retail, hotel and office segments.
Aside from its immediate impact, the pandemic has also clouded the outlook for commercial real estate as trends such as the decline in demand for traditional brick and mortar retail in favor of e-commerce or for offices as work-from-home policies have emerged. Recent IMF research has shown that these trends could disrupt the commercial property market and potentially jeopardize financial stability.
The link to financial stability
The commercial real estate sector has the potential to affect overall financial stability: the sector is large; The price movements tend to reflect the broader macro-financial picture. and it depends heavily on leverage.
In many economies, commercial real estate loans make up a significant part of banks’ loan portfolios. In some countries, non-bank financial intermediaries (e.g. insurance companies, pension funds or mutual funds) also play an important role, although banks remain the largest providers of debt financing to the commercial real estate sector worldwide. An adverse shock to the sector can put pressure on commercial property prices, adversely affect borrowers ‘credit quality, and weigh on lenders’ balance sheets.
The risk of price erosion increases when we observe large price misalignments – that is, when prices in the commercial real estate market differ from those implied by economic fundamentals or “fair values”. Our latest analysis shows that these price misalignments increase the downside risks to future GDP growth. For example, a 50 basis point decrease in the capitalization rate from the historical trend – a commonly used measure of misalignment – could increase the downside risk to GDP growth in the short term (accumulated over 4 quarters) by 1.4 percentage points and by 2.5 percentage points in the medium term (accumulated over 12 quarters).
The heavy toll of COVID-19
Looking at the impact of the pandemic, our analysis also shows that price misalignments have increased. Unlike in previous episodes, however, this time around, the misalignment isn’t due to excessive leverage, but rather a sharp drop in both operating income and overall demand for commercial property.
As the economy becomes more dynamic, the misalignment is likely to decrease. Nonetheless, the potential structural changes in the commercial real estate market will challenge the sector due to evolving preferences in our society. For example, a permanent 5 percentage point increase in commercial property vacancy rates (due to a change in consumer and business preferences) after five years could result in a 15 percent decrease in fair values.
However, one has to keep in mind that the outlook for commercial real estate is very uncertain, which makes a final assessment of price misalignments extremely difficult.
The role of policy makers in addressing financial stability risks
Low interest rates and easy money will help non-financial companies maintain access to credit, supporting the emerging commercial real estate recovery. However, if these simple financial conditions encourage too much risk taking and contribute to price mismatches, policymakers could turn to their macroprudential policy toolkit.
Tools such as LTV limits or debt service coverage ratios could be used to address these vulnerabilities. In addition, policymakers could seek to extend the reach of macroprudential policy to non-bank financial institutions, which are increasingly important players in the commercial real estate finance markets. To ensure the banking sector remains strong, stress testing could help make decisions about whether adequate capital has been allocated to cover exposure to commercial real estate.
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