➤ The macroeconomic environment remains a challenge for commercial real estate assets mostly linked to interest rates.
➤ E-commerce growth impacts logistics, while decarbonization drives capex increases.
➤ Robust underwriting and funding diversification are key strengths in the current market.
Underlying problems within the commercial real estate sector and geopolitics are among the factors that could delay the sector's recovery, an expert said during a recent S&P Global Market Intelligence webinar.
Shivani Phegade, associate director for credit and risk solutions at Market Intelligence, said the increased refinancing risk observed in 2022, which was attributed to limited access to capital markets and more expensive bank lending, is projected to ease as interest rates start to decrease and asset values stabilize.
Key risk factors for real estate under construction and in operation include lease maturity concentration and market and financial risks. Variability in loss given default is expected, influenced by cash flow riskiness, loan seniority and legal environments, Phegade said.
Commercial real estate (CRE) assets have struggled, particularly due to the impact of interest rates.
High interest rate impact
"The economy has been resilient, yet it has been tough on commercial real estate assets, and that's mainly because of the impact of interest rates," Christophe de Noaillat, director of credit and risk solutions at Market Intelligence, said during the webinar.
Higher interest rates have led to decreased property values and increased debt servicing costs, making refinancing efforts more challenging. For unhedged floating rate loans, debt servicing costs have even doubled or tripled. Rising interest rates have also adversely affected capitalization rates, which are derived from dividing cash flows by property value, leading to decreased property values.
Inflation-linked leases have helped alleviate some debt-service burdens, but construction projects face headwinds from slower economic growth and rising raw material costs.
While there are healthy debt yields, refinancing has proved to be challenging. In certain markets, leases indexed to inflation have helped mitigate debt servicing costs, but certain sectors have had to re-index leases to alternative measures like turnover, de Noaillat explained.
Access a replay of the webinar and the presentation slides.
Shifting market dynamics
The shift to hybrid work and economic deceleration are putting pressure on secondary office stock, while e-commerce is expected to grow, albeit at a slower rate, impacting logistics.
"Retailers now want to combine both the online channel and the physical channel, which means there is a knock-on effect since the beginning on logistics," de Noaillat said.
This integration in the retail space has prompted several changes, such as the relocation of last-mile logistics facilities. In the US, for instance, we are witnessing the repurposing of vacant secondary malls for last-mile logistics purposes, de Noaillat said.
In addition, increasingly stringent decarbonization regulations are expected to drive capital expenditure increases in the coming decades.
Credit quality stays strong
Amid the challenges, the average credit quality remains strong due to robust underwriting practices over the past decade, which have allowed healthy loan-to-value levels.
Also, funding diversification is becoming more prevalent, with debt funds complementing traditional lending for suitable properties.
"When we see banks reducing their exposure, we see private debt funds picking up the slack," de Noillat said.
Overall, the CRE sector must navigate a complex landscape of economic and regulatory challenges, leveraging strong underwriting and diversified funding to maintain stability.
While the credit environment has improved, the process of evaluating risk has become more intricate. Lenders must thoroughly assess individual sectors and properties to determine their exposure to defaults and losses.
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