Banking sector stress elevates real estate uncertainty
March 22, 2023
Recent failures and rescues in the banking sector have caused significant volatility in the global financial markets. The situation is fast moving but the latest indications are that, despite elevated uncertainty, initial fears that events could escalate into a full-blown financial crisis have moderated.
Some concern remains around the prospects for smaller regional banks, particularly in the United States where they account for almost 70% of commercial property lending. Given the current repricing of real estate and potential for distress in some parts of the sector, this could be a further source of stress.
However, the Federal Reserve and other central banks have acted quickly to ensure liquidity in the financial markets. Together with other market participants, they have moved to support sentiment and contain the potential fallout from what currently appear to be institution-specific, rather than systemic, problems. The banking sector is better regulated, better capitalised and has higher liquidity than in the pre-GFC era. This is particularly true in Europe, where even smaller banks have been subject to tight regulation, rigorous stress tests and have increased their hedging of interest rate risk more significantly than their U.S. counterparts.
The markets have not yet normalised and sentiment remains vulnerable to any further signs of banks in distress; the situation still requires careful monitoring, but there is good reason to be optimistic that the point of greatest risk is behind us. However, we do now expect a further tightening of credit standards for bank lending for firms and households. This will dampen demand and result in lower economic growth. Goldman Sachs expects U.S. credit standards to tighten more than during the dot-com crisis - but less than in the GFC or at the height of the pandemic – which they estimate will have a 0.25% point drag on 2023 US GDP growth, equivalent to 25-50 bps of rate hikes.
All this begs the question: what are the implications for interest rates and the real estate sector?
This week sees key interest rate decisions from both the Federal Reserve and the Bank of England. The ECB first tested investors’ reaction to a further tightening of policy in the current uncertain environment with a long-planned increase of 50 bps last week. Given the ECB hike did not prompt a market backlash, this will have given comfort to the Fed and the Bank of England that they can continue to tighten policy given the strength of recent economic data and that inflation remains unacceptably high. Both decisions will have been finely balanced. The Fed opted to push ahead with a 25 bps increase, which is smaller than many were expecting but which reflects their concern over the need to prioritise the fight against inflation. They clearly feel that other the other measures they have taken will be sufficient to maintain liquidity. The BoE were stating that they were in “wait and see” mode following their recent series of rate hikes, but Wednesday’s UK inflation data took an unexpected jump upwards which we believe will persuade them to follow the Fed with a further 25 bps increase– but again this will be a close call.
The recent signs of stress in the banking sector, however isolated they may appear to be, will inevitably dampen investor sentiment and business confidence. This will result in higher risk aversion, lowering government bond yields as investors view them as a safe haven. Ten-year government bond yields in North America, Europe and the U.K. – the so-called “risk free rate” – are around 50 bps lower than they were a couple of weeks ago, albeit trending back upwards as investors recover from the initial shock of events in the banking sector. This will potentially ease some of the fundamental pressure on real estate repricing. Swap rates – which reflect the “basic” cost of commercial borrowing – have also fallen. We are now expecting rates to peak lower than we thought a fortnight ago and believe they will be cut faster next year than previously appeared likely. This should be positive for property in H2 2023 and throughout 2024.
For now, however, banks are likely to be even more conservative in lending across the board, with those willing to lend demanding a greater risk premium on real estate loans. This suggests the property debt market will remain particularly constrained until more clarity emerges. Investors are also likely to take a more cautious approach to re-entering property markets which have been correcting for several months now. We continue to see investors working quietly to secure opportunities to buy at attractive prices, but a heightening of uncertainty will keep some of this capital on the side lines longer than we previously expected. Due to events in the banking world, the timeline for a recovery in real estate investment volumes has been pushed backwards, at least by a month or two.
That said, the environment for refinancing existing loans has become even more challenging and we may also see further outflows from some open-ended funds. Both pressures could force more disposals into a market where a significant amount of capital is awaiting the right opportunity to deploy. When the tide turns, we believe it could do so quite quickly. Those with equity to deploy and with no immediate need to secure debt finance could see further openings in the market, and fewer competitors with sufficient conviction to act, in the months ahead.