Hopes in the commercial real estate sector that central banks would lower interest rates due to declining inflation have been dashed. Interest rates are staying high for longer, causing problems, particularly for those who borrowed heavily during the market boom to fuel growth and who now face the burden of refinancing their debt.
The commercial real estate market is under even greater strain as interest rates continue to rise and remain high. Prices for offices, residential buildings, and other commercial properties have already fallen by several tens of percentages depending on the type of property and the country. However, owners who wish to offload properties have been reluctant to accept these reductions, hoping for better times when interest rates would fall and prices recover. This scenario can now be dismissed. Rates are set to rise further due to stubborn inflation, leaving heavily indebted parties watching the clock.
In Sweden, the stock price of real estate investor SBB (Samhällsbyggnadsbolaget i Norden) has plummeted over 90% since the start of 2022. The credit rating has been downgraded to junk, and a previous attempt to raise capital failed. The new CEO is now exploring the sale of strong assets to raise cash, hoping to sell off the remaining half of its educational real estate to Canadian real estate investor Brookfield. Time is running out for SBB, which needs to repay €1.5 billion ($1.68 billion) in short-term loans.
SBB is not alone in facing a wall of refinancing. Bond investor Pimco estimates that up to $650 billion in real estate loans need to be rolled over in Europe by 2025. Globally, this figure stands at $2,400 billion. “We expect reduced liquidity, pressure on underlying fundamentals, and geopolitical tensions to lead to pain in the short and medium term,” according to the bond investor. The upcoming wave of refinancing, Pimco says, will force a reckoning.
Mismatch between supply and demand
SBB is negotiating with its back against the wall, and if the discount is large enough, there will always be a deep-pocketed buyer like Brookfield. But in the rest of Europe, real estate owners are not yet ready to take such steps. “There is a mismatch between demand and supply. Buyers are not willing to pay what sellers are asking,” confirms Madeline Buijs, Chief Economist at real estate advisor Colliers. “That makes the situation quite complicated at the moment.” According to Buijs, there was an expectation that more transactions would occur after the first quarter. “But now, the second quarter has passed, and the third has already begun.”
In Germany, the transaction volume in commercial real estate halved in the first half of the year to €14.9 billion ($16.8 billion), according to data from real estate advisor JLL. This is the lowest level since 2017. In the Netherlands, too, the number of transactions has declined, and office vacancy rates are rising slightly.
Problems years in the making
The current problems in commercial real estate have been years in the making. Central banks’ loose monetary policy drove up prices over the past decade. Investors took on debt to expand portfolios and buy properties at ever-higher prices. This strategy worked as long as interest rates were falling. Lower financing costs still yielded good returns. Meanwhile, investors benefitted from the persistent appreciation of the bricks and mortar. Firms like Sweden’s SBB used this to take on even more debt.
But the math no longer adds up due to the abrupt increase in interest rates. On the main office markets in Europe, such as Paris, Frankfurt, and Amsterdam, an initial return of 3.5% to 4% is achieved on average. This is feasible with a policy rate close to 0%, but at present, due to the increased interest rates, a real estate investor needs to pay 5% or 6% for new financing. This means that rents must significantly increase - often not possible in the short term - or debt must be reduced to cut financing costs. Moreover, the higher interest rates have reduced the value of the real estate.
“When selling assets, the moment of ‘price discovery’ arrives, the point at which the price level becomes clear,” says Robert Stenger, Asset Manager at Van Lanschot Kempen. “Those under pressure are selective in their measures. First, they lower dividends and try to get their finances in order internally,” Stenger explains the market stagnation. “Raising new capital is the last resort. The sector isn’t there yet.”
Fear of contagion effects
The share prices of real estate funds have already anticipated a correction. The sub-index for real estate in the pan-European Stoxx 600 fell 42% since the beginning of 2022. Investment portfolios of non-listed real estate were written down in valuations this year. Also, real estate bonds decreased in value. The spreads over risk-free interest rates have increased. In 2021, spreads typically ranged between 70 and 100 basis points. This is now 220 basis points. Yet, nobody knows if enough pain has been taken. If firms like SBB run into payment difficulties, this affects lenders and banks. This can then lead to the financial contagion effects European and national regulators have been warning about for months.
The Bank for International Settlements (BIS) - the bank of central banks - indicates in its annual report how long it may take for the stress of a series of interest rate increases to subside. “Since 1970, banking stress manifested in almost 20% of the cases within three years after tightening of monetary policy. An increase in inflation and high private debt make stress more likely.” That’s roughly the situation the world is in now, observes the BIS. “The risk of self-reinforcing adverse macro-financial effects is significant.”
Bracing for a harsh wind in home markets
One of the companies under pressure is German real estate giant Vonovia. Since the beginning of 2022, its share price has dropped by 63%. This residential investor experienced rapid growth through acquisitions and high debt. Now, a harsh wind is blowing in its home markets of Germany, Sweden, and Austria. The Dutch pension administrator APG is the third-largest shareholder in Vonovia with a 4% stake.
Vonovia’s Q1 earnings paint a picture of a firm trying to hold on to its cash. Vonovia reduced its investments in renovation, maintenance, and new construction by 33% to €341 million ($384 million). The dividend was also reduced. Despite these measures, the debt relative to the investment portfolio increased. The loan-to-value ratio increased by 1.5 percentage points to 46.6%. The net debt-to-EBITDA ratio rose by thirty basis points to 16.1 by the end of March. Half-year results will be released on August 4.
Opportunity for those with solid cash reserves
So, is it all doom and gloom for everyone? Not for those parties with well-stuffed coffers. In April, private equity firm Apollo purchased a 30% stake in a housing portfolio from Vonovia for $1 billion, naturally at a discount. Furthermore, Apollo will receive 70% of the dividends from the homes in Baden-Württemberg and does not have to pay an asset management fee. Thus, a golden deal indeed.
Stenger and Aan den Toorn from Van Lanschot Kempen anticipate that real estate investors with strong management teams and robust balance sheets will seize their opportunity in the coming times. Stenger: ‘When there is fear, and the entire sector goes down, it provides fantastic opportunities for those who do their homework. Management teams that have already experienced several crises know that during such a period, the returns for the next ten, fifteen years are earned.’
Copyright: Het Financieele Dagblad, 11 July 2023. This article was originally written in Dutch by FD journalist Ahrend Clahsen. It was translated using artificial intelligence and then edited. Find the original at https://fd.nl/financiele-markten/1478963/rente-blijft-langer-hoog-dat-d…