Commercial Real Estate Faces Economic Crash Worse Than 2008, Warns Morgan Stanley

The European commercial real estate sector is facing a potential crisis due to the Covid-19 pandemic and the turmoil in the financial sector. The collapse of Silicon Valley Bank in March 2022 and subsequent economic fallout have only further strained the commercial real estate market. Banks are increasingly hesitant to lend out of fears that they could default and be unable to make good on those loans if depositors rush to withdraw their funds simultaneously. In addition, the European Central Bank (ECB) has urged regulators to develop policies that prevent liquidity mismatches in open-ended property funds, which own assets that take a long time to sell but promise to repay investors on demand. It fears that fire sales of assets to meet redemptions could amplify existing stresses.

Commercial real estate makes up 9% of European banks’ loan book, on average, according to Goldman Sachs, and 15% of non-performing loans. However, the European average hides a wide range, and some banks have larger commercial property exposure than others. For example, Nordic banks had the largest commercial property exposure, according to an S&P Global Market Intelligence report late last year. HSBC, whose real estate lending has grown in recent years, still had only 11% exposure, S&P said.

But banks are not the only lenders. Private debt funds, which are unregulated at this point, are also a concern. "What concerns me is outside the banking sector, what is called ‘shadow banking'," says Lux, of Bayes Business School. "Private debt funds are unregulated at this point." Alternative lenders now occupy the terrain that banks held during the financial crisis. "The debt funds that have stepped into that highly leveraged space have got to be in a worse position [than banks]," says Bladon, of Investec.

However, the growth of alternative sources of lending such as asset managers, sovereign wealth funds, and private equity firms could also provide a key source of financing for the industry as banks draw in their horns, according to Ron Dickerman, president of investment group Madison International Realty. Some of the demand for loans and fresh investment could be met by funds that raised large amounts of cash in recent years and have yet to deploy it, as well as overseas investors. But they may also choose to invest those funds outside the challenged office and retail markets.

The first in line to take losses will be the owners of lower-grade office buildings. They face a "perfect storm" of weaker underlying demand for space, higher construction and maintenance costs, fewer potential buyers or lenders, and higher interest charges. Some assets, and likely some companies, will need a fresh injection of equity to reduce the leverage in their capital structures. In more extreme scenarios, they may have to sell assets to pay down debt. Real estate executives will find themselves heading into these high-stakes talks just as banks have less room to be lenient because turmoil in the financial sector has damped their tolerance for risk.

“In the very short term, we may see banks navel gaze a bit and make sure that they go over what they have got on their balance sheet, at the expense of new origination,” says Anthony Mongone, real estate partner at the law firm Ropes & Gray. Net lending to commercial property in the UK turned negative to the tune of £288mn in February, for the first time since August. Capital Economics analysts expect that pull back will accelerate given the banking turmoil, “which will constrain the eventual recovery in investment and construction”.

The chief concern is a wave of forced selling from over-extended asset owners or debt funds, which would further depress the value of assets and create a downward spiral. Commercial property prices have already turned down, and Morgan Stanley analysts forecast prices could fall as much as 40%, rivaling the decline during the