The Credit Suisse crisis was instructive in several ways but the most important lesson was despite its relatively solid balance sheet, when sentiment (or momentum) turned savagely bearish, the fundamentals simply didn’t matter. In a liquidity crunch, no amount of equity (or AT1 bonds) will save you from becoming roadkill.

Like Credit Suisse, commercial real estate has been in investors’ bad books for some time: work from home, slowing economic growth and the increasing cost of debt made sentiment remorselessly negative and then along came the collapses of SVB and Signature banks in the US.

Suddenly every hedge fund manager I talk to is talking from what looks like the same script. Chief talking points include: the US regional banks were always big lenders to the main property funds and now they’re in trouble – small and medium-sized banks that make up the bulk of US lenders account for about 70% of commercial real estate loans, according to JPMorgan analysts.

If that wasn’t bad enough the commercial lending securities market which allows the regional banks to offload debt to institutions has also frozen up and interest rate spreads increased. The Financial Times reports on ‘a slow market for commercial mortgage-backed securities, which is squeezing the ability of banks to free up lending capital by shifting existing loans off their books, and also reducing the exits available to other sources of funding such as the private markets. Issuance of the bonds, as with their residential mortgage cousins, is running at a fraction of the levels of recent years.’

This turn of events has come at a rather unfortunate point in the medium-term financing cycle for commercial real estate. According to Elon Musk, the next five years will see more than $2.5tn in commercial real estate debt mature, which is more than any five-year period in history.

US vacancy rates soar

If all that wasn’t bad enough vacancy rates in the US have risen in each of the top 25 markets since 2019, according to rating agency Moody’s. In San Francisco, the worst-hit city, almost 19% of space was unoccupied at the end of 2022, up from 5% three years earlier. As a result, more and more developers and investors are handing back the keys: the FT, again, reports that ‘Canadian property giant Brookfield last month stopped making payments on $734m of loans covering two prime Los Angeles office towers while one of New York’s biggest office landlords, RXR, said it was negotiating with lenders to “hand back the keys” to two buildings in an acknowledgment that they no longer made financial sense.’

Given all this negative publicity it probably won’t come as a surprise to hear that the big US investment banks – who of course sold those commercial securities – have turned negative on the sector. Analysts at Morgan Stanley have recently gone on record warning that ‘in US commercial real estate, we expect significant further price declines in Office (~40% peak-to-trough), a level that would exceed the peak-to-trough decline over a 28-month period during the Great Financial Crisis. Expected peak-to-trough declines in Apartments (-15%) and Retail (-30%) would be smaller, but still significant.’

Unsurprisingly, real estate securities are under pressure with European property stocks underperforming US stocks and UK property shares underperforming the Europeans. The markets seem to be telling us something – property stocks may own real assets which should benefit from an inflationary shock, but liquidity issues look like they might trump those virtues.

Veteran investment commentator Charlie Morris nicely sums it up thus: ‘What’s interesting is how property was highly correlated with bonds, but that has now changed. The recent banking crisis saw government bonds rally, but this time property didn’t follow. The message from property is that the “safe” income stream we have become used to, is under pressure.’

UK Reits retreat

UK-listed real estate investment trusts have also been caught up in the selloff: most of the leading UK listed Reits trade at very substantial discounts to net asset value (NAV). But market data on the UK commercial property doesn’t quite suggest a property market meltdown – at least not yet.

Investment company analysts at Numis Securities report that investment volumes in UK commercial property totalled £54bn in 2022, 3% above the five-year average but 5% below 2021. Volumes fell in each quarter throughout 2022, with the fourth quarter of 2022 being the lowest level recorded since the second quarter of 2020 when the Covid-19 pandemic struck.

They also cite data from Savills which shows ‘a marginal decrease in availability for regional office stock across ten regional UK markets, with total supply falling by 1% to 14.4m square feet, resulting in supply falling 2.2% below the 10-year average. This marks the first year that supply of office stock has decreased since 2019, driven by the fall in secondary office supply. The overall vacancy rate for regional offices increased from 12.5% to 12.6% over the year, but remains in line with the 10-year average.’

So, is the gloom on the UK Reit sector over done? The broader market data suggests a slowdown but no hard reset. Another way of answering this is to look at three sets of numbers recently reported by very different listed Reits.

Let’s start with the most conventional fund: UK Commercial Property Trust (UKCM ) which has a diversified mix of industrial and office assets. Like many Reits it reported a fairly dramatic drop in NAV of 18.1% for last year but the underlying fundamentals don’t look quite so bad: EPRA earnings per share increased 19% to 3.15p and occupancy rates remained largely unchanged at 98% (2021: 97.9%). The leverage of the portfolio remains low at 20% group loan to value (LTV) with a blended interest costs of 3.68% of which 68% is at fixed rates. The shares trade at a 35% discount to NAV.

Arguably if any fund was going to see weakness in the bottom line from a slowing UK economy, it would be Regional Reit (RGL ) – its very name tells you that it doesn’t focus on the supposedly high quality London office assets that are so prized. For the 2022 financial year NAV per share tumbled 24.3% to 73.5p due to increasing yields, while on a like-for-like basis NAV declined 12.1% during the year.

Yet net rental income increased by 12.2% and rent collection in 2022 was 98.7%, up from 97.7% the previous year and vacancy rates were practically unchanged at 12.6%. Rent roll increased by 7% with 14.5% of the rent roll coming up for renewal in the next 12 months.

Like many Reits its balance sheet seems stable – analysts at Liberum report no debt maturing in the next two years and interest rates hedged so that the maximum cost of debt will not exceed 3.5%, although the LTV has risen towards 50% which is towards the top of the range for most Reits. The fully covered yield is at 11% and the shares trade at a 21% discount.

Last but by no means least Impact Healthcare Reit (IHR ). Most investors think of prime offices when they think of commercial real estate but in the UK market, this is overshadowed by much bigger sub-sectors such as health property – in market value terms UK commercial is a £2.7bn sector compared to £3.6bn for healthcare.

Crucially, many of these widely held sub-sectors aren’t, currently, being hit by weaker trading. Impact for instance reported a 2022 NAV decline of just 2%, helped along by rental growth. The closed-end fund benefited – like many – from its inflation-protected leases although most contracts seem to have a cap of 4% which makes the inflation hedge less durable. Then again there were zero voids and 100% rent collection for 2022.

The key point is that most good funds are reporting rental growth – that limited inflation linkage helps – with relatively low voids. Leverage (via LTVs) seems low, and loan maturities extend some way out from here and, though increasing, payments manageable. NAV write-downs are the rule although they are largely driven by valuation model changes. Discounts are also high – as the table below which shows the various property sub-sectors on differing measures, some sectors such as housing have abnormally high discounts.

UK Reit key data

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Sub-sector	Average share price discount %	12-month low discount %	Market value £	Net asset value return year to date %	One-year NAV return %	Yield %
UK Commercial	27.1	43	2.7bn	1.7	-11.9	6.3
Industrial	18	40	3.96bn	-1.2	-4.7	5.3
Residential	41.9	45	2.8bn	1.1	14.1	8.3
Student	2.8	18.5	4.4bn	-1.8	9.4	3.4
Healthcare	11	21	3.6bn	-8.7	-3	6.9

 

The bad news is that there are also some challenges – as the table also shows, dividend yields though adequate aren’t that high with 6% net yields common. In the era of cheap money, 6% was impressive – less so now. I worry that voids might start increasing as economic activity slows down.

So, what might happen next? Back to my initial point about roadkill. It’s noticeable that even bearish investment banks such as Morgan Stanley think UK property stocks are in a less precarious position, with lower leverage and recent rental growth. Blackstone’s swoop on Industrials Reit (MLI) this week also reminds us that big US majors know that UK Reits – in the right sector – are cheap and are willing to snap up what they regard as cheap assets.

My hunch is that sentiment is still overwhelmingly negative and that if US commercial real estate does stumble – and there must be a decent chance of that happening – then UK Reits will get hit. My bet is we won’t see a trough until mainstream Reits retrace their journey back to a 40% average discount. The worst is probably still to come but given the decent fundamentals, the rebound could be quite aggressive – with more outfits like Blackstone swooping in to buy cheap stuff.

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