Looking again at the market sectors in and around the UK in light of Covid 19, this week we look at the commercial markets.
Pretty much everything about the current economic contraction is unprecedented — but one very familiar phenomenon could be emerging that will extend and deepen the crisis.
The health of the commercial property sector is always a key indicator for financial and corporate regulators. When big problems emerge there, they have a real risk of endangering the rest of the property sector, the financial system, and the wider economy.
Commercial property isn’t just office towers and shopping centres — in central locations, it includes large and medium sized residential developments with lower levels often comprising commercial and some retail accommodation as well. Mixed use developments predominate particularly in the larger UK centres of London, Liverpool, Manchester and other centres where there are denser agglomerations of similar buildings and concentration of population. Developments of student focused accommodation in regions similar to Liverpool appear particularly exposed as international arrivals have declined to almost 0. Developments that are mid way through the construction or planning phase are vulnerable and particularly so as Institutional investment on which many are based begins to contemplate reduced earnings and possible losses.
But large losses in commercial property classes such as CBD office blocks or hotels are usually where problems emerge ahead of traditional recessions.
In some countries some banks fell over and had to be rescued. Outside banking, numerous property trusts failed and had to be cut adrift.
Over 20 years later, the pandemic is a very different kind of crisis. The REIT (Real Estate Investment Trust) is weakening and is slowing a slide in values as vacancy rates increase, required incentives to attract and retain tenants are increasing and the nature and extent of transactions decline. Real returns are declining due to investors and share holders reducing retirement incomes which is having a negative affect on confidence.
The sector was patchy going into the crisis. Retail has been struggling for some time due to wage stagnation and a long-term shift from goods to services consumption, including travel and dining out. But others saw an opportunity in commercial property.
Overly high asset valuations and declining sales were also likely to see some investors breaching loan covenants, while developers may fail to turn a profit and be left holding inventory and debt, Banks are warning.
Both pose problems for lenders. Commercial property represents about a lower percentage amount of the banks’ assets, but a higher level for non-bank lenders who are thus more exposed to a commercial property crunch.
But on top of the immediate hit from the pandemic, there is a very real possibility of secular change in demand for office and retail space. How many firms, having discovered the extent to which they can continue operating with staff working from home, are going to retain the same level of leased office space after the pandemic?
United Kingdom shopping centre owners may face the same grim environment as US retail, where major chains were closing or filing for bankruptcy even before the pandemic.
As we found in the early-90s, ultimately these problems end up with lenders. The major banks are better capitalised now, and it may not become the systemic threat it was in the 1990s.
But a commercial property shock could still hold back a recovery that will require big growth in business investment and banks ready to support that with lending.
AND we still have Brexit to deal with…