After ten years of ‘free’ money, it is impossible for interest rates to rise as steeply as they have without repercussions in the financial system. So far, this has manifested primarily among smaller US banks which lent to tech companies. However, there is a clear sense of risk in the wider banking sector owing to interest rate rises, a fall in the value of banks’ asset bases and depositor nervousness.
For now, relative calm has descended on financial markets. However, a key unknown for US banks remains the valuation prospects for loans made against offices, given the skew towards hybrid working in the US.
A direct problem for real estate investors could emerge if we were to see a wave of loans go into distress. While this cannot be ruled out, there is good reason to believe that the current banking turmoil will be contained.
Relative to crises banks have faced in the last 50 years, they are in a better place. A surge in risky lending in the late 1990s through to the mid-2000s created uncertainty over the quality of banks’ loan books, precipitating a systemic collapse in the banking sector during the global financial crisis.
The nature of the problem was similar during the US Savings and Loans crisis of the 1980s and 1990s. Then, banks struggled following interest rate rises and an exodus of depositors. Subsequent deregulation designed to revive them fueled a surge in risky lending, resulting in widespread bank insolvencies.
Lessons have been learned; European banks in particular are more tightly regulated and better capitalized today. While a key source of today’s uncertainty stems from the future for offices, it represents a fraction of the uncertainty banks faced during the global financial crisis. And that crisis remains too fresh in people’s minds for lenders to have relaxed underwriting standards over the last decade. Importantly, unlike the run-ups to previous crises, this time around leverage has remained modest and relatively cautious.
Policymakers have also been swift and robust in their remit to maintain financial stability, signaling that bank deposits will be guaranteed. This support has helped to reassure markets and may already be preventing contagion.
Moreover, expectations around interest rates have shifted dramatically. Given increased risk in the banking sector, we could now be closer to a peak in the interest rate cycle. An increasingly risk-off approach by banks could reinforce this potential, through proxy monetary tightening.
There is good reason to believe that the current banking turmoil will be contained.
While banks are less vulnerable than they once were, a fall in asset values still means balance sheets are weaker. Against this backdrop, the cost of debt is likely to increase and/or remain high, even if base rates moderate.
Tighter credit conditions could also have wider implications for real estate and the economy, limiting the potential for economic growth through business expansion, for example. While a recession may still be avoided in the UK and Eurozone, limiting any weakening of rental fundamentals, property values could face further declines, partly as a result of a narrower buyer pool.
Risk in the banking sector cannot be ignored but it is a question of how deep it becomes. We believe tighter credit conditions are inevitable. But a full escalation of the banking crisis is not. The magnitude of real estate repricing is subject to a number of variables, however the likelihood of severe and prolonged valuation falls could be overstated.
For banks and real estate investors, gaining insight on office property valuations is going to be crucial in the next few years.