Commercial Real Estate Sector Faces Risks as Financial Conditions Tighten

After

taking a hit

at the onset of the pandemic, the commercial real estate sector—properties
primarily owned for investment purposes—has been on the mend. Prices of
industrial and residential properties have surged globally since the end of
2020, while the worst-affected retail and office segments have shown some
signs of stabilization.

The momentum, however, seems to be losing steam as global financial
conditions have tightened this year as central banks shift to hiking interest rates. As our Chart of the Week shows, property prices in the industrial and residential segments have, on
average, experienced a deceleration across regions in recent months. At the
same time, the depreciation in retail and office property prices has
increased.

Tighter financial conditions tend to have a direct impact on commercial
property prices by making it more expensive for investors to finance new
deals or refinance existing loans, thereby lowering investment in the
sector. They could also have an indirect impact on the sector by slowing
economic activity, reducing demand for commercial property such as shops,
restaurants, and industrial buildings.

In a

recent analysis, we find that financial conditions are indeed an important driver of
commercial real estate prices, and they help to explain the divergent
performance of the sector across regions during the pandemic.

In general, economies with easier financial conditions (that is, lower real
interest rates and other market conditions that make it easier to obtain
financing) saw a smaller decline in commercial property prices during the
pandemic and a faster recovery. Commercial property prices have also been
higher in countries which implemented relatively less stringent public
containment measures to control the spread of the virus, rolled out larger
fiscal support packages, and have a higher vaccination rate.

A sharp tightening in financial conditions could thus put the commercial
real estate sector under renewed pressure, especially in regions where
economic growth prospects are weak and if stringent containment measures
need to be put in place to curb new waves of infections.

Our analysis also suggests that trends catalyzed by the pandemic, such as
working from home and e-commerce, have an impact on commercial real estate
prices.

Increased teleworking, for example, tends to reduce demand for office
space, while e-commerce adversely affects the price of retail real estate
as consumers shop online. As considerable uncertainty surrounds the future
pace and extent of such structural shifts, tighter financial conditions
could compound these effects and exacerbate downward price pressures in the
affected segments.

Disruptions in the commercial real estate market could in turn potentially

threaten financial stability

through the connectedness of the sector with the financial system and the
broader macroeconomy. Continued vigilance is warranted on the part of
financial supervisors to mitigate such risks.

To ensure banking-sector resilience, stress-testing large declines in
commercial real estate prices should be conducted to inform decisions
regarding the adequacy of capital buffers for commercial real estate
exposures. Banks’ commercial real estate valuation assumptions should also
be reviewed to ensure that provisions are adequate. In regions where
nonbank financial institutions are important players in commercial real
estate funding markets, efforts should focus on broadening the reach of
macroprudential policy to cover these institutions to mitigate systemic
risks.