Commercial real estate markets after the end of “low for long”: Risks and policy challenges

– By Caroline Roulet –

Real estate assets are the largest store of wealth in the OECD countries, valued at USD 111 trillion in 2022, nearly twice the level of GDP. Commercial buildings, plus other corporate structures, at an estimated USD 38 trillion, account for more than one-third of these assets. Conditions in many commercial real estate markets have worsened significantly since 2022, when the long period of low interest rates came to an end. Recent OECD work documents sizeable declines in commercial property prices, particularly in the United States and the euro area, driven by both higher global interest rates and changes in demand induced by growing teleworking and e-commerce. At the same time, the financing costs of property developers and risk premia for low-rated commercial mortgage-backed securities have risen, and the performance of specialised institutions such as commercial real estate investment trusts and funds has weakened.

The exposures of financial intermediaries to commercial real estate are estimated to have totalled USD 21 trillion in 2023 (Figure 1), based on available data for individual institutions across a large number of economies. Although bank loans are the largest single source of exposure, the combined exposures of diverse non-bank sources have risen over time and now exceed 50%. In particular, commercial real estate investment trusts and funds have become increasingly important over the past fifteen years, especially in advanced economies. Debt accumulation by commercial real estate investment trusts and property developers is reflected in a substantial increase in outstanding bonds and syndicated loans, and a growing reliance on private capital.

Figure 1. Worldwide financial sector exposures to commercial real estate are very large

Note: This figure provides estimates of commercial real estate (CRE) exposures for both bank and non-bank financial intermediaries. Data are expressed in trillion US dollars adjusted by 2023 US consumer price index. See note of figure 1.6, Box 1 and Annex B in Roulet (2024) for further details.
Source: IMF FSI, OECD National Accounts, National central banks and office statistics, LSEG, Pitchbook, OECD calculations.

Commercial property developers face mounting credit quality challenges, with the amount of low-credit-quality debt recently surpassing levels in the global financial crisis (Figure 2, Panel A). Developers in emerging-market economies are particularly affected, but credit quality has also deteriorated in advanced economies (Figure 2, Panel B). Moreover, the maturity profile of bond and syndicated loan redemptions implies substantial refinancing needs in the next few years, particularly for leveraged borrowers (Roulet, 2024). Delinquency rates on commercial mortgage-backed securities are also rising, amidst a growing number of missed mortgage payments by borrowers with commercial real estate loans.

Figure 2. Across the world, the quality of property developers’ debt has often deteriorated

Note: Four types of companies are shown in the chart. Corporates with a “sound credit risk profile” are ones with a leverage ratio (measured by the ratio of debt to EBITDA) between zero and 5 and an interest coverage ratio (ICR) higher than 2. The other three types of companies all have a leverage ratio either above 5 or below zero (due to negative EBITDA). Among these, “leveraged distressed” corporates have an ICR lower than 1, “leveraged at risk” corporates have an ICR between 1 and 2, and “moderately leveraged” an ICR higher than 2. Debt data include the total debt reported on the liability side of the balance sheet. See Annex B in Roulet (2024) for further details.
Source: LSEG, OECD calculations.

These developments raise potential financial stability risks, reflecting the growing exposures of various interconnected financial intermediaries. The higher financing costs and lower earnings of commercial property developers could raise banks’ non-performing loans and generate losses for non-bank financial intermediaries. Significant losses at specialised commercial real estate investment trusts could spread to real estate investment funds, raising investor redemptions and potentially triggering downward price spirals from fire sales. Insurance companies’ solvency ratios and pension funds’ liquidity could also be adversely affected by losses, both directly from their commercial real estate loans and indirectly through their linkages with real estate funds.

Policy challenges remain in assessing and mitigating risks from commercial real estate exposures. Significant data gaps hinder accurate analysis of the exposures of many financial intermediaries. For instance, breakdowns of commercial real estate exposures by asset classes and type of collateral are often missing. Existing macroprudential tools in commercial real estate finance, such as capital buffers or loan-to-value ratios, are also primarily bank-based, with limited measures available to mitigate risks in non-banks. The use of these tools can also vary across jurisdictions.

Many policy tools to help monitor and mitigate financial stability risks from the commercial real estate sector need to be developed further, including:

• Cross-country agreement on a precise definition of commercial property assets and the development of common qualitative and quantitative indicators (ESRB, 2023a).
• Increased evaluation of the credit quality and loss-provisioning of commercial real estate portfolios held by both banks and non-bank financial intermediaries (ECB, 2023; ESRB, 2023b; IMF, 2024), along with enhanced stress-testing of banks. Such tests should take account of indirect exposures to commercial real estate through the bank funding of non-banks.
• Improved assessment and mitigation of liquidity mismatches and leverage risks for institutional investors and real estate investment funds, including constraints on redemptions in the latter (FSB, 2023; IOSCO, 2024).
• Further work on borrower-based measures, especially for non-bank financial intermediaries, and enhanced international cooperation to help limit regulatory fragmentation. Such measures should include limits on excessive indebtedness and regulations to ensure solid credit quality and adequate repayment capacities.

References:

ECB (2023), Real Estate Markets in an Environment of High Financing Costs, Special Feature, European Central Bank, Financial Stability Review, November.
https://www.ecb.europa.eu/press/financial-stability-publications/fsr/special/html/ecb.fsrart202311_02~75cf0710b9.en.html.

ESRB (2023a), Vulnerabilities in the EEA Commercial Real Estate Sector, European Systemic Risk Board, January.
https://www.esrb.europa.eu/pub/pdf/reports/esrb.report.vulnerabilitiesEEAcommercialrealestatesector202301~e028a13cd9.en.pdf.

ESBR (2023b), Macro-financial scenario for the 2023 EU-wide banking sector stress test, European Systemic Risk Board, January.
https://www.eba.europa.eu/sites/default/files/document_library/Risk%20Analysis%20and%20Data/EU-wide%20Stress%20Testing/2023/Scenarios/1051432/2023%20EU-wide%20stress%20test%20-%20Macro%20financial%20scenario.pdf.

FSB (2023), Revised Policy Recommendations to Address Structural Vulnerabilities from Liquidity Mismatch in Open-Ended Funds, Financial Stability Board, December.
https://www.fsb.org/uploads/P201223-1.pdf.

IMF (2024), The Last Mile: Financial Vulnerabilities and Risks, Global Financial Stability Report, Chapter 2, April.
https://www.imf.org/en/Publications/GFSR/Issues/2024/04/16/global-financial-stability-report-april-2024.

IOSCO (2024), “Revised Recommendations for Liquidity Risk Management for Collective Investment Schemes”, Consultation Report, The Board of the International Organization of Securities Commissions, November.
https://www.iosco.org/library/pubdocs/pdf/IOSCOPD770.pdf.

Roulet, C. (2024), “Commercial real estate markets after the end of “low for long”: risks and policy challenges”, OECD Economics Department Working Papers, No. 1829, OECD Publishing, Paris.
https://www.oecd.org/en/publications/commercial-real-estate-markets-after-the-end-of-low-for-long-risks-and-policy-challenges_0f9ae118-en.html.