Commercial real estate: risks during and after the pandemic

COVID-19 has hit the commercial real estate sector hard and has led to more uncertain prospects for some of its segments.

Risks of financial stability during and after the crisis caused by the epidemic are discussed in great details in the recently released IMF Global Financial Stability Report. Let's dwell on its main theses.

What is going on

The restrictive measures imposed in response to the proliferation have seriously affected economic activity. As a result, the global volume of transactions and prices of commercial real estate in 2020 have fallen dramatically.

While there were no significant price discrepancies at the beginning of the pandemic, some countries are now showing signs of inflated levels. Actual prices did not decline as much as one would expect based on fundamental economic factors.

Commercial real estate price imbalances, especially when combined with other vulnerabilities, increase negative risks to future growth due to the possibility of sharp price corrections. Such adjustments could threaten financial stability and adversely affect corporate investment, hindering economic recovery.

Among the main segments of commercial real estate, retail space, hotels and offices have suffered the most. At the same time, the situation in the industrial segment is relatively better.

The negative impact on the retail, office and hospitality segments may be partly irreversible, as some activities may continue to be carried out virtually in the future, while others will move from large cities.

The large size of the commercial real estate sector and its heavy reliance on debt financing (in which banking and non-banking financial institutions play a significant role, as well as cross-border investors in some jurisdictions) suggests that these developments could have potentially significant financial stability implications.

Price discrepancies in this market have increased during the pandemic and could exacerbate the risk of future slowdowns in GDP growth through potentially large price corrections.

Why is it important

Unfavorable price shocks for commercial real estate worsen the creditworthiness of borrowers in this market, weaken the solvency of lenders and lead to a reduction in investment in the non-financial corporations sector.

The dynamics of recovery in this sector will objectively depend on the structural shifts caused by the pandemic. However, there are still grounds to continue supportive policies to maintain easy financial conditions, keep credit flowing to the non-financial corporations sector, and stimulate aggregate demand to promote recovery in the sector.

At the same time, soft financial conditions may contribute to the build-up of vulnerabilities and chronic price imbalances.

Statistics shows a strong relationship between the severity of quarantine measures and the decline in commercial activity.

As lower incomes lead to lower debt-servicing capacity and expectations of higher NPLs on commercial real estate loans, credit markets quickly became tense.

This is evidenced by the surge in overdue payments on commercial mortgage-backed securities, a type of fixed income investment product backed by commercial mortgages real estate.

While general delinquency rates have been found to follow through with performance during the financial crisis, delinquency in the retail and hospitality sectors reached record highs in the second quarter of 2020.

In addition to the short-term impact, the pandemic has also exacerbated pre-existing structural trends in some market segments.

This is especially true in the retail segment, where demand for traditional retail has been on a gradual decline even before the pandemic, as consumers increasingly switched to e-commerce.

The COVID-19 shock could also result in a sustained adverse effect on demand for offices and hotels as businesses adopt more liberal work-from-home policies and replace large in-person meetings with online meetings.

These trends indicate that the commercial real estate sector will face challenges in the near term and a very uncertain outlook, especially for some segments, in the long term.