'Commercial real estate: the crisis is worse than the Great Financial Crisis - Morgan Stanley and other top 5 institutions.'
'let's take a look at recently published reports from Capital Economics, PwC, Morgan Stanley, Bank of America, UBS and Goldman Sachs.
Capital Economics
Capital Economics says office values are unlikely to recover by 2040. In a report by Kiran Raichura, deputy chief real estate economist, Capital Economics compares the office sector to shopping centers, which it says have not recovered. Both sectors are experiencing a lack of demand, and in the case of offices this is due to a shift to working from home. The research firm suggests that "the 35% drop in office values that we forecast by the end of 2025 will probably not be recovered even by 2040," meaning that office values will probably not reach their pre-pandemic peaks over the next 17''years.
The reason is that office utilization has dropped to 50% of pre-pandemic levels (which were already at 70% -75%). This low utilization is forcing companies to downsize their physical space, resulting in vacancy rates rising to 19% in the first quarter of this year, compared to 16.8% in the last quarter of 2019. However, Raichura says the actual increase is about double when sub-vacant space is taken into account. Thus, the office vacancy rate has already increased more than that of shopping centers from 2016 to 2023. In addition, large office owners are already returning their abandoned properties to lending institution owners, which the firm says is likely to increase following an increase in delinquencies for commercial''mortgage-backed securities seen in May. At the same time, real estate investors are gradually abandoning office investments. After more than three years of decline, the rate of return on office investment funds has fallen by more than 50% compared to the overall rate of return on investment funds, similar to the decline in the rate of return on shopping center investment funds during the early years of the retail sector correction, Capital Economics notes. This all suggests that the road ahead for office owners will be "tough," as Raichura said, without focusing on the overall state of commercial real estate.
PwC
PwC says commercial real estate is not in crisis. In an interim forecast, PwC simply says that''commercial real estate is not collapsing. Despite the Federal Reserve raising interest rates, which has increased borrowing costs, and a pandemic that has changed the way people work, PwC says there are still opportunities for deals in the future. "We believe the sector is not in crisis as successful deals will find opportunities, and green shoots are visible in all subsectors, including the promising office subsector," PwC notes.
Till then, transaction volumes declined in all commercial real estate sub-sectors in the first quarter of this year compared to the same period last year. Office transactions were down 68%, hotels down 55% and industrial down 54%, the report states. However, PwC expects''return of rental activity and deal flow with improved interest rates and economic policy. For the time being, however, the sector will continue to face headwinds and dealmakers may need to get creative. "Commercial real estate assets face several challenges amid higher interest rates and reduced demand from banks for lending in this area," PwC said.
Morgan Stanley
Morgan Stanley predicts something "worse than the Great Financial Crisis" in their bearish outlook. Lisa Shalette, chief investment officer at Morgan Stanley Wealth Management, sees a "huge hurdle" ahead for commercial real estate, especially office space that is experiencing rising vacancy rates''and cost reductions since the pandemic. At the same time, the whole sector is facing a wave of loan maturities, probably in the face of stricter lending requirements. This is likely to lead to increased delinquencies and defaults and lower real estate values, which Shalett confirms in his assessment.
Bank of America
Bank of America believes the challenges are "manageable" for three reasons. Bank of America analysts repeatedly emphasize that the challenges facing commercial real estate are manageable, and they cite several reasons why. But first, let's take a look at what Bank of America sees as the two main challenges. The first is high inflation, which has led to higher Federal Reserve interest rates, making servicing commercial mortgages more costly. The second is remote work, which has proven to be a continuation of the pandemic and has significantly reduced demand. "We conclude that the challenges are real and significant, but for several reasons they are manageable and not''pose a systemic risk to the U.S. economy,' Bank of America analysts wrote.
What are some of the reasons? First, there are financing tactics that commercial real estate borrowers can use to avoid defaulting on their debt, such as loan modifications and extensions. Therefore, 17% of the loans that analysts say will expire this year can be refinanced using tactics that will potentially protect struggling borrowers from increased costs in today's economic environment. Second, Bank of America analysts say office space represents 23% of all commercial real estate mortgages, but only 3.8% of total commercial real estate. Finally, improvements in''lending since the Great Financial Crisis means loans have become less risky. Bank of America analysts found that debt service coverage ratios are significantly higher and leverage to real estate value ratios are significantly lower, indicating a shift from loyal lending before the Great Financial Crisis.
UBS
UBS says "headlines are worse than reality" but things could get worse in the event of a recession. Analysts at international investment bank UBS say "headlines are worse than reality" and a repeat of 2008 liquidity is unlikely. In their less pessimistic tone, analysts say that about $1.2 trillion of the total $5.4 trillion''commercial real estate debt (other than multifamily buildings) should expire, probably at higher interest rates. However, this is expected to add to existing problems in the office sector (which they say accounts for 15% of total commercial real estate value), rather than creating systemic risk. But it does mean that office space owners may be more likely to default on their debt. "There are currently about $1.3 billion of office mortgages scheduled to expire in the next three years," the analysts wrote. "Some of these loans may have to be restructured, but the scale of the problem is incomparable to over $2 trillion of bank capital. Share of offices in banks''represents less than 5% of total loans and only 1.9% for large banks'.
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