The drop in European Commercial Real Estate values and transaction volumes in 2022 reversed the sentiment of 2021. This re-rating also generated lots of buy recommendations from across the real estate investment manager universe. Whilst 2022 year end valuation reports aren't yet due, the latest round of interest rate rises and banking stress has institutional investors inside RFPnetworks asking, are commercial real estate about to drop.
The impact of interest rate rises on bank profitability is not uniform across the UK/Europe and the U.S.. In Europe rate rises have been a net positive for profitability. In the U.S., the story is more complex.
In the U.S., up until mid 2022, most banks were in better shape than at any time since the Global Financial Crisis. Bank funding was at the most conservative levels in decades, as measured by loan/deposit and loan/earning asset ratios. In fact, deposits were funding the highest level of bank assets since 2008.
But rapid rate rises since then have resulted in record levels of deposits being withdrawn. Competition from money market funds has increased. This trend may be likely to continue as the yields, liquidity, and the security of a diversified portfolio of issuers gives depositors a compelling alternative, on the back of already nervous depositors. The sticky nature of deposits at regional banks, is no longer a given. But this is not the complex issue.
The real complexity comes from how these deposits have been deployed in the U.S., compared to UK/Europe. Compared to European banks, the top 25 banks in the U.S. have 2x the exposure to commercial real estate. The statistics are even pronounced when drilled down to regionals banks, where the exposure is 6x that of European banks. There are over 4000 U.S. banks outside of the top 100.
Compared to pre-GFC, loan-to-value and debt service coverage ratio's are much more conservative. But as cap rates adjust to higher interest rates and slowing growth, valuations may continue to drop from where they are today. Price pressure may also accumulate as banks factor in the regulatory capital charges on their loan book, as commercial real estate valuations drop.
With the latest round of interest rates rises, there is a belief that central banks are more concerned about inflation compared to growth. But that does not necessarily mean that inflation is more important than stability.
Investment managers inside RFPnetworks quantify a possible correction for CRE of 20-25% from current levels, with logistics being more resilient than office or retail. The good news is that given the fundamentals, a drop of 40-50% on CRE would be required before these loans become unprofitable.
Nevertheless, history is making investors nervous. In the period between 1980 and 1994 almost 3000 U.S. financial institutions failed. Of which, over 1000 during the Savings & Loans crisis of the 1980s. This was a partial result of losses on commercial real estate loans. Inflation may be FED priority number one today, but financial institution instability is in no-ones interest.
The institutional real estate investors inside RFPnetworks are therefore researching on two levels: Firstly, the relative value of CRE regionally and by segment; And secondly, they are also reading the outlooks from fixed income managers, to gain even more perspective on CMBS, rates, inflation and growth. Times are stressful, which usually means investors can pick up prime opportunities at distressed prices.
