The real estate downturn stands to get worse

Here are five ways the bank crises in the US and Europe will make it more challenging for transaction activity to bounce back.

Swiss bank UBS’s planned acquisition of its troubled rival Credit Suisse on Sunday was met with a collective sigh of relief around the world. The transaction – involving two of the 30 global systemically important banks – staved off near-certain catastrophe in the global banking system.

Ultimately, however, the news does not give private real estate much reason to celebrate. With 2022 a subdued year for investment, many had hoped transaction activity would rebound by mid-year. Now the prospect of a 2023 recovery looks increasingly remote as the uncertainty surrounding the banking crises in the US and Europe will keep buyers and sellers on the sidelines for some time to come. Here are five reasons why.

1. Borrowing costs will become even more expensive

Despite higher interest rates being cited as a major factor behind the recent bank crises, more monetary tightening is underway. Following the European Central Bank’s decision to move ahead with a 50 basis point rate increase last week, the Federal Reserve and Bank of England each voted to raise rates by 25 basis points this week. Rising rates will continue to push already elevated borrowing costs higher. Borrowing costs on outstanding asset-level debt for funds in the MSCI/PREA US AFOE Quarterly Property Fund Index already reached 4.4 percent by the end of December, the highest level since late 2013, according to MSCI’s February 2023 US Big Picture report published this week.

2. The bid-ask spread will widen further

The fallout from the Silicon Valley Bank and Signature Bank failures in the US will lead real estate values to correct more significantly than expected. In a research briefing this week, Oxford Economics forecasted all US property values would fall by 10 percent in 2023 and 5 percent in 2024. This additional projected pricing decline would further widen the bid-ask spread between buyers and sellers. Of the latter group, many have yet to accept pricing adjustments and are unlikely to do so unless they are under pressure to sell.

3. Banks will be less active commercial property financiers

Banks represented a total of 48 percent of new loan originations last year, with regional and local banks accounting for 27 percent, according to the MSCI report. The majority of banks reported tightening standards for all types of commercial real estate loans during Q4 2022, according to the Federal Reserve’s January 2023 Senior Loan Officer Opinion Survey. Smaller lenders now face further constraints in the wake of the regional bank shutdowns. “Ultimately, less activity on the part of banks would mean that commercial transaction activity will be even more measured,” Cushman & Wakefield chief economist Kevin Thorpe, head of economic analysis & forecasting Rebecca Rockey and head of investor insights Abby Corbett noted in an analysis last week.

4. Alternative lenders could also come under threat

Non-bank financial institutions have grown rapidly globally and now account for almost $240 trillion – or just under half – of total global financial assets, according to the Oxford Economics briefing. These groups have also been significant lenders in commercial real estate, but many have relied on banks for their own borrowing needs. “The key downside risk for the property outlook is that banks – facing liquidity constraints – withdraw funding from non-bank lenders, who are then forced to sell assets to make up financing shortfalls,” chief global economist Innes McFee wrote in the report.

5. A 2023 recession has become much more likely

The bank turmoil increased the odds of a near-term recession, which will further dampen already softening tenant demand, Lee Menifee, PGIM Real Estate’s head of Americas investment research, remarked in a video that appeared on LinkedIn this week. As tenant demand drops amid an economic slowdown, so will net operating income, a key figure in assessing a property’s value and a borrower’s ability to make its mortgage payments. Even with multiple catastrophes averted over the past week, a recession, compounded with all of the aforementioned headwinds, would mean that the industry is still in for a painful year ahead.