Rents or rates: what is driving the commercial real estate market?

Prepared by Alessandro Cavalleri, Giorgia de Nora and Ellen Ryan

Published as part of the Financial Stability Review, November 2024.

Understanding the drivers of the current downturn in commercial real estate (CRE) can provide insights into the outlook for the market and potential spillovers to the financial system and wider economy. The CRE market is facing the simultaneous effects of higher interest rates, falling demand due to a structural shift towards remote working and rising costs from higher sustainability-linked capex requirements. Understanding the role of each factor in driving prices and firms’ profits can provide some insight into how financial stability risks from CRE might evolve over the coming quarters. For example, the pressure from high interest rates could soften with a potential further easing of monetary policy, while structural factors appear unlikely to change. Moreover, spillovers to the financial system – such as deteriorating credit quality in banks’ CRE loan books – and the wider economy could differ, depending on the nature of the market downturn.

Chart A

The CRE market downturn has been driven by both monetary policy and falling CRE demand, with the latter likely to persist due to structural change

a) Decomposition of drivers of CRE price growth	b) Impact of monetary, CRE demand and construction supply shocks on GDP
(percentage share of various shocks to house prices dynamics)	(percentage deviation of GDP from initial level)

Tight monetary policy and adverse CRE demand shocks have been the main factors pushing CRE prices down since the start of 2022 (Chart A, panel a). While the downward pressure exerted by tight monetary policy is expected to decline going forward, the impact of lower CRE demand will likely persist where it is driven by pandemic-induced structural changes in preferences and new remote working practices. By contrast, construction supply shocks have played a relatively less important role in recent years. Even so, falling numbers of new building permits in many countries suggest that construction activity may start to decline in the coming quarters.^[1] This is relevant to the extent that a large negative real estate construction supply shock could have particularly severe real economy spillovers, with the BVAR model showing the biggest GDP impact from this shock (Chart A, panel b).

Chart B

Asset write-downs have been a primary driver of falling profits among real estate firms; the sector is also seeing falling interest coverage ratios

a) Drivers of real estate firms income	b) Dynamics of key ratios in recent years
(Q1 2015-Q2 2024, percentages)	(Q1 2018-Q2 2024; left graph: percentages, right graph: multiples)

With falling prices, asset write-downs have been the primary driver of the recent sharp drop in the headline profits of real estate firms. Declining profitability could affect the debt repayment capacity of real estate firms, with spillover effects on the credit quality of banks’ CRE loan books. Decomposing the profits of 100 of the euro area’s largest public real estate firms shows that asset write-downs have played an outsized role in driving recent declines in profits (Chart B, panel a). Like market price fluctuations, asset write-downs are likely caused by both monetary policy and reduced demand for CRE (Chart A, panel a). In light of falling CRE prices, it is important that asset write-downs are recognised to ensure that firms’ balance sheets accurately reflect their financial health. Aggregate asset write-downs posted since the start of 2022 come to just -3.05% of the value of real estate owned by firms prior to monetary tightening, although there is significant variation across firms. Compared with a cumulative market price correction of -11%, this suggests that some firms may need to recognise further write-downs in the coming quarters.^[2] Asset write-downs may not immediately affect the resources available to firms to meet debt repayments, meaning that the immediate spillovers to the credit quality of banks’ CRE loan books may be limited. However, this reduction in asset values – and hence collateral values – may still pose challenges to firms when they seek to refinance their debts. Reduced access to funding could force them to deleverage, thus amplifying the CRE demand shock mentioned above and further depressing market prices.

Real estate firms’ revenue growth has not kept pace with their financing costs, which has potential implications for their repayment capacity. Unlike asset write-downs, falling revenues or rising costs will affect the resources available to firms to meet debt repayments. As a result, fluctuations in these factors will have immediate implications for credit quality. For the sample of firms examined, the ratio between revenue and expenses remained broadly stable over the period studied, suggesting that this sample of large firms has not seen capex costs exceeding their rental growth (Chart B, panel b).^[3] While rental growth has kept pace with expenses for large firms, financing costs have increased disproportionately. The median real estate firm saw its interest coverage ratio drop from 4x to 2x over the course of the monetary tightening cycle, although with some recovery since the start of 2024 (Chart B, panel b). This will likely have immediate implications for the capacity of firms to meet debt repayments, with clear spillovers to bank and market credit risk. While any potential further monetary easing may reduce pressure on repayment capacity in the coming quarters, firms may still see financing costs rise as the debt that originated during the period of ultra-loose monetary policy matures. Indeed, as of June 2024 20% of loans to euro area real estate firms were due to mature within two years.^[4]