Commercial real estate at a crossroads – IMF blog


Through Andrea Deghi and Fabio Natalucci

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Empty office buildings. Reduced store hours. Incredibly low hotel room rates. All are signs of the times. Containment measures put in place last year in response to the pandemic have shut down businesses and offices and hit demand for commercial real estate, particularly in the retail, food and beverage segments. hotels and offices.

The commercial real estate sector has the potential to affect broader financial stability.

Beyond its immediate impact, the pandemic has also clouded the outlook for commercial real estate, given the advent of trends such as declining demand from traditional retail to e-commerce, or for commercial real estate. work-from-office offices – home policies are gaining ground. Recent IMF Analysis notes that these trends could disrupt the commercial real estate market and potentially threaten financial stability.

The financial stability link

The commercial real estate sector has the potential to affect broader financial stability: the sector is large; its price movements tend to reflect the larger macro-financial picture; and it relies heavily on debt financing.

In many economies, commercial real estate loans form a significant portion of banks’ loan portfolios. In some jurisdictions, non-bank financial intermediaries (for example, insurance companies, pension funds or investment funds) also play an important role despite the fact that banks remain the largest providers of debt financing. of the commercial real estate industry globally. A negative shock to the sector can put downward pressure on commercial real estate prices, adversely affect the credit quality of borrowers and weigh on lenders’ balance sheets.

The risk of falling prices increases when one observes price misalignments—It is when market prices for commercial real estate deviate from those implied by economic fundamentals or “fair values”. Our recent analysis shows that these price misalignments amplify downside risks to future GDP growth. For example, a 50 basis point decline in the capitalization rate from its historical trend – a commonly used measure of misalignment – could increase the downside risks to GDP growth by 1.4 percentage points in the near term ( cumulatively over 4 quarters) and 2.5%. medium-term points (accumulated over 12 quarters).

The heavy toll of COVID-19

Looking at the impact of the pandemic, our analysis also shows that price misalignments have increased. Unlike previous episodes, however, this time around the misalignment is not the result of an excessive build-up of debt, but rather a sharp drop in both operating income and overall demand for commercial real estate. .

As the economy grows, the misalignment is likely to decrease. Nonetheless, potential structural changes in the commercial real estate market due to changing preferences in our society will challenge the sector. For example, a permanent increase in vacancy rates for commercial buildings by 5 percentage points (due to a change in consumer and business preferences) could cause fair values ​​to decline by 15% after five years.

It should be borne in mind, however, that there is enormous uncertainty about the outlook for commercial real estate, which makes a definitive assessment of price misalignments extremely difficult.

Role of policy makers in addressing financial stability risks

Low rates and easy money will help nonfinancial businesses continue to have access to credit, thus contributing to the nascent recovery of the commercial real estate sector. However, if these easy financial conditions encourage too much risk-taking and contribute to price misalignments, then policymakers could turn to their macroprudential policy toolbox.

Tools such as limits on loan-to-value ratios or debt service coverage could be used to address these vulnerabilities. In addition, policymakers may seek to broaden the scope of macroprudential policy to cover nonbank financial institutions, which are increasingly important players in commercial real estate finance markets. Finally, to ensure the soundness of the banking sector, stress testing exercises could help inform decisions on whether adequate capital has been set aside to cover exposures to commercial real estate.

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