The Fed hikes until something breaks. Whether this statement is fair on the US central bank or not – correlation is not causation – history generally supports it. So as we approach the end of the rate hiking cycle, investors are sensitive to any perceived economic vulnerability.

For a short time it was the banking system. Instead, March 2023 may be remembered for the financial crisis that never happened. But US banks remain under pressure from deposit flight, raising the prospect of a credit crunch as they scale back some lending practises.

This has put the spotlight on commercial real estate (CRE), given US regional banks have been active in lending against domestic real estate, unburdened by the regulatory constraints of the large ‘systemically important’ banks.

The listed market indicates where investor sentiment currently sits. Equity REITs underperformed the market last month, despite other rate-sensitive sectors outperforming on the back of falling rate expectations. 

The first point to note is that banks don’t dominate CRE debt markets, due to shifting attitudes to risk and greater regulatory constraints. Despite the actions of regional banks, they still only account for around 30 per cent of US CRE debt.

This means that there are plenty of alternative lenders; dry powder across unlisted debt funds targeting the US has increased nearly threefold since 2019, and there remains plenty of investor interest given the potential for debt to provide high stable returns and seniority in the capital stack.

Secondly, banks aren’t in the business of ‘loan-to-own.’ So we’re likely to see more restructured deals rather than outright distress. Indeed, to date the prophesised wave of distress hasn’t materialised; the delinquency rate of US CRE loans at end-2022 was under 0.7 per cent, compared with 10 per cent during the GFC.

Most debt held by the regional banks isn’t due for several years, while large banks have much lower exposure to CRE loans (as a percentage of their overall lending books), which means there’s scope for non-performing loans to rise without leading to major solvency concerns.

The other important consideration is that much of the debt due over the next few years will be long term, which means that price growth since origination should provide some flexibility to landlords. Similarly, lower LTVs provide a cushion for lenders even if there’s a rise in distress, with plenty of scope to dispose of failing assets without incurring large losses.

Clearly this is an over-simplification, and ignores that some assets will experience considerable falls in valuations. But the performance of office-REITs relative to other listed real estate highlights another important distinction; much recent commentary conflates the whole CRE sector with offices.

CRE is very idiosyncratic, and for many sub-sectors the fundamentals remain solid. Even the story behind offices is complex. Continued income growth may allow the fabled ‘extend and pretend’ to pay off, especially if inflation follows the path of least resistance and interest rates continue to fall.  

Looking ahead, we’re going to see tighter credit conditions as banks retrench. This will feed through to asset values. Inevitably, we’re also likely to see further polarisation in the market – between the best and worst assets, tenant covenants, and borrowers. 

Meanwhile, alternative lenders will fill any void left by banks. But it will come at a cost for landlords; higher rates bring into focus interest coverage ratios and future income growth projections. For some, this won’t be worth bearing, especially those holding poorly performing assets, or loans originated since Covid-19.

But unless there’s major disruption to income growth, underpinned by a sharp economic deterioration, a ‘doom loop’ scenario where the banks and the CRE sector bring each other down remains a tail risk event. Certainly, commercial property isn’t broken.

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Contact Oliver Salmon

Real estate capital markets: where next?