Rate cut hopes fuel bets real estate crisis is easing

Commercial property stocks and bonds are rallying as forecasters widely predict the end of a market slump triggered by a multi-trillion-dollar debt burden. Real estate investment trusts (REITs), the stock-market-listed commercial building owners, have rebounded to levels last seen before U.S. lender Silicon Valley Bank collapsed in March 2023, sparking fears of a major credit crunch for landlords. Commercial property bonds are also pricing better times ahead as flows into property investment funds pick up. The rally is pegged firmly on hopes that major central banks will cut interest rates from multi-decade highs, relieving intense pressure on landlords and their lenders and driving forecasts that buildings will stop losing value. "We're close to the bottom of the market, we really believe it," said Kim Politzer, head of European real estate research at Fidelity International. "For us, it seems sensible now to be planning to deploy more money into it."

With UK commercial property values down by about 25 per cent from a mid-2022 peak, Nick Montgomery, head of UK real estate investment at Schroders, said Britain's market was "at or near the bottom", pointing out that rents were up 4 per cent in 2023. BlackRock, the world's largest asset manager, also said, opens a new tab this month that 2024 would be "an entry point" for cheap real estate investments worldwide.

HIGH HOPES, BIG RISKS

The remarkable rally clashes with continued warnings from major regulators about the perils faced by the sector, including from the president of Germany's financial regulator, who on Tuesday described commercial real estate as "risk No. 1". ”In the last month, in terms of market sentiment, there has been a markedly positive change towards real estate," said Bernie Ahkong, co-chief investment officer of UBS Asset Management's hedge fund unit O'Connor (UBSG.S), opening new tab, adding he had not bought into the rally.

According to data provider Lipper, global property funds attracted an estimated $82.2 million of net inflows in the week to Jan. 10, the highest seen since September 2021. Real estate stocks, Ahkong explained, tend to rise when traders believe the cost of landlords' debt will fall and had attracted those "looking to play duration," a term for buying assets that are sensitive to interest rate changes. Commercial landlords have more than $2 trillion of loans due for refinancing globally by end-2025, according to consultancy Jones Lang LaSalle. A significant minority face difficulty renegotiating these borrowings unless the U.S. Federal Reserve and the European Central Bank cut rates swiftly, as markets predict. Money markets are betting on the Fed dropping its funds rate from 5.25 per cent to 5.5 per cent to below 4 per cent by December. 

Ratings agency S&P Global has put almost a third of European real estate groups and about a fifth of U.S. landlords on notice for a debt downgrade, because they would struggle financially if rates do remain high.

GREEN SHOOTS?

In 2023, the volume of commercial property transactions was more than 50 per cent lower than in 2022 in both the U.S. and Europe, according to MSCI. Office vacancies, according to MSCI's latest available data, are 17 per cent in the U.S. and 14 per cent in Europe. Still, some evidence suggests the gloom is lifting. Declines in real estate values, as illustrated by the total returns investors in property-owning investment funds are achieving, have moderated after falling by the most in the year to October 2022 since the 2008 global financial crisis. "We're not in a bull market," said Anne Koeman-Sharapova, head of real estate investment for Europe at consultancy Mercer. "But valuation data and public equities are showing things are turning around." Recovery is expected to be patchy, with investors predicted to favour Europe over the United States.

Capital Economics, the research consultancy, forecasts that values of commercial buildings in the UK will rise 1.1 per cent this year after dropping 4 per cent in 2023. Euro zone real estate prices should turn positive in 2025, Capital Economics forecasts, while the U.S. will lag substantially with a 10 per cent drop this year and no recovery until 2026, thanks to its particularly sharp office demand slump. Even U.S. credit investors are turning optimistic on real estate however, with an index of bonds issued by U.S. REITs, opens new tab back at levels last seen before the Fed embarked on its aggressive rate rise cycle in March 2022. Yuri Seliger, credit strategist at Bank of America, said the Fed's rate rises had been the main cause for concern about U.S. real estate. "The whole issue was due to the Fed's hiking cycle, which is supposedly coming to and end in 2024," he said, "so the outlook is improving."