Britain’s Marks and Spencer, which announced 7,000 job cuts earlier this week, has been busy closing stores, as have countless other retailers. On both sides of the Atlantic, hallowed retail names such as Brooks Brothers, Neiman Marcus and Debenhams have also fallen into bankruptcy. Many corporate giants around the world meanwhile plan to rationalise office use with a balance of working at home and hot desking at the office. Rent arrears are in the billions. In short, a toxic combination of coronavirus and soaring online sales, the so-called Amazon effect, have rocked the commercial property market.
Since property collapses frequently lead to banking crises, this should ring alarm bells. Have central banks and financial watchdogs underestimated the threat posed by collapsing real estate prices to the financial system?
Assessing the extent of the damage in commercial property is tricky because the market is by its nature opaque, and valuations are slow to reflect falling prices when markets plunge. That said, quoted real estate investment trusts, or Reits, provide a useful guide.
The Bank for International Settlements, the central bankers’ bank, calculates that in the US, UK, continental Europe and Japan the Covid-19 shock has wiped out Reits’ cumulative valuation gains of the past five years. By comparison, stock market indices at the depth of the crisis in early March lost only the gains they had made in 2019. Reits have also lagged behind the stock market recovery that began in April.
Property deals are being called off. Property companies are also scrambling to raise money in bond markets and tap unused bank facilities. In the view of one seasoned property expert, innumerable properties in the US and UK are now worth less than the debt that was used to finance their purchase. At the same time, delinquencies in the commercial mortgage-backed securities market, which is mainly centred in the US, are escalating. Credit rating agencies expect overall delinquency rates to approach the same levels that were reached in the 2008 financial crisis towards the end of the year.
None of this is pretty. Yet there are good grounds to believe it does not augur a system-wide threat to financial stability. To start with, property crises that have proved lethal in the past were due to extreme credit cycles in which the market acted as a residual sink for surplus liquidity. Such cycles create an excess supply of new developments, causing prices to plunge. This was the background to the 2008 subprime crisis, as well as the late 1980s to early 1990s property crises in the US, Europe and Japan, and the mid-1970s crisis in the UK.
Today, there is less evidence of an imbalance of supply and demand. In the City of London office market, usually an excellent barometer of excessive risk taking, oversupply is not an obvious problem. Much of the space being built is under offer or pre-let. The same is true across most of the developed world.
As for the structural challenge posed by more working at home, Mike Prew, a Jefferies analyst who highlighted retail property’s problems at an early stage, argues that Zoom will not do to offices what Amazon has done to shopping centres. In the post-coronavirus world, he foresees softer office rents and a shakeout in which the losers are older tall buildings with small lifts and creaking ventilation systems. This is hardly the stuff of financial catastrophe.
In the meantime, agents LaSalle point out that across Europe prime office yields — rental income expressed as a percentage of the property’s capital value — have been relatively stable. The retail sector is where yields have risen and prices have fallen most conspicuously.
Yet even in retail, coronavirus has simply accelerated the pre-existing shift from bricks and mortar to ecommerce and technology — as embodied in Apple’s $2tn market capitalisation this week. Also striking is that residential property has been buoyant in the US despite Covid-19, and also in the UK where the government has helped with temporary stamp duty exemption. This is in marked contrast to 2008.
The key remaining question is whether banks have sufficient capital to cope with both a high level of corporate defaults and distressed property prices. In fact, their capital has been substantially increased since the last crisis on the basis of regular stress testing by central banks. The severity of these tests has varied, being conspicuously less stressful in continental Europe than in the US and UK. But even if authorities do underestimate the damage that falling property prices could inflict, a sizeable buffer exists; the monetary and fiscal policy response to Covid-19 also appears to have put a floor under asset prices. Panic selling was restricted to a short period around March.
So a banking crisis, while not inconceivable, does not feel imminent. The underlying problem in property may best be seen as an extension of the corporate sector’s wider problem with excessive debt. After scrambling this year to raise funds to cope with the rental shortfall, property companies remain vulnerable to interest rate or earnings shocks. The villain of the story, then, is the virus and the subsequent lockdown of economies in response. Rather than a saboteur, the real estate sector is just another victim.
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