Real Estate Risks Are Global, but Impacts and Perceptions Vary

Slower economic growth, inflation and rising interest rates have taken a toll on real estate markets, and risk managers are on high alert. An October 2023 GARP Benchmarking Initiative (GBI) survey reflects the global scope of real estate risk concerns, though perceptions vary by property type and geography.

China’s real estate markets – both residential and commercial – were deemed most risky by the survey’s nearly 500 FRM-certified respondents, almost half of whom were from China and other Asian countries. (Most of the rest were from the Americas and Europe.) However, within commercial real estate (CRE), risk in the office category was rated higher in the U.S. than in China.

And while respondents in China gave residential real estate the highest risk rating, those in the U.S. saw domestic residential real estate as least risky.

Figure 1: Residential Real Estate Risk Across Different Regions
How would you rate the current risk in residential real estate?
(Average score ranging from 1 for “very low” to 7 for “very high”)

Source: GARP Benchmarking Initiative (GBI), “Risk Snapshots” survey, October 2023

In another indicator aligning with the GBI results, the Federal Reserve’s most recent Financial Stability Report, in October, included a “survey of salient risks” in which three-fourths of participants mentioned “the potential for large losses on commercial real estate and residential real estate.”

Residential Lock-In

The variability across markets may be attributable to economic, political and other factors. In the U.S., prior to the recent climb of mortgage interest rates to above 7%, homeowners were able to refinance at historically low fixed rates. The result is what Cristian deRitis, deputy chief economist at Moody’s Analytics, described as a “lock-in effect,” where homeowners are not incentivized to refinance or move.

Mortgage activity and housing supply have consequently fallen across the U.S. Yet the S&P CoreLogic Case-Shiller National Home Price Index rose for seven consecutive months and hit all-time highs in August. Median home prices rose in September by 2.8% year-over-year, according to the National Association of Realtors.

“So there’s less chance of a major correction,” said Kishore Yalamanchili, GARP director of risk content, adding that while existing home sales are static, there is nevertheless significant demand for housing that is reflected by strong new-home sales, which quickly absorb any new supply.

The lock-in effect actually benefits investors in residential mortgage securities backed by Fannie Mae and Freddie Mac, the bulk of the U.S. market, since their biggest risk is prepayments. Tracy Chen, portfolio manager at Franklin Templeton’s Brandywine Global, said that while it may be premature to trade fixed-rate residential mortgage-backed securities (RMBS), since mortgage rates may climb further, agency-MBS may outperform investment-grade corporate bonds in a recession.

CRE Bottleneck

China’s real estate troubles stem largely from overbuilding fueled by loose credit. The U.S. and Europe were plagued by the pandemic downturn and its after-effects. The CRE office sector is affected by vacancy rates exacerbated by the remote-work trend. Survey respondents in the U.S. and Europe said more than 45% of employees work remotely up to three days a week, compared with 20% in China.

Figure 2: Remote Work Has Increased Less in China Than in Other Regions
(% of respondents whose firms’ employees work remotely up to 3 days/week on average)

Source: GARP Benchmarking Initiative (GBI), “Risk Snapshots” survey, October 2023

An extreme case is San Francisco, where, the Wall Street Journal noted, the debt of numerous stressed properties is tied to commercial mortgage-backed securities (CMBS). The California city’s office woes are attributed in large part to its concentration of technology companies whose employees have flexibility to work remotely. New York City’s financial companies have been pressing their workers to return to the office, but not all for five days a week. Boston may fare better than those cities because its bioscience community depends on employee presence and interaction.

U.S. office sector transactions have practically halted, so although prices have fallen, valuations are inexact. Chen said that unlike public real estate investment trusts (REITs), most private firms have yet to mark down their books.

“For the CRE market to revive, they have to capitulate and mark their properties to market,” the Brandywine Global portfolio manager said.

She added that the average cap rate – a building’s net income divided by its price – is currently just over 7% for the office sector, compared to the 10-year Treasury bond rate recently touching 5%. Historically, that spread is around 400 basis points, suggesting the cap rate should be closer to 9%, thus requiring office prices to fall.

“We’re probably in the early innings for the CRE market because there’s no capitulation – no price transparency – currently,” Chen said.

Figure 3: Highest CRE Risk Types

How would you rate the current risk for each type of commercial real estate?
(Average score ranging from 1 for “relatively low” to 5 for “relatively high”)

Source: GARP Benchmarking Initiative (GBI), “Risk Snapshots” survey, October 2023 

More visibility into CRE valuations may be on the horizon, said Yalamanchili, pointing to reports that firms including Cohen & Steers, Goldman Sachs and EQT are raising billions of dollars for funds to buy distressed assets. Still, some properties may not be salvageable. Shopping malls, for example, are seeking to shift away from shopping to more entertainment-oriented themes and dining.

“They’re changing their business models, but at the same time, America has been over-malled,” he remarked. “That’s going to be corrected, and as these loans come due and default, we’re going to see a renormalization of the malls in America.”

Eventual Reckoning

The $400 billion to $500 billion of office loans set to mature annually over the next several years could face major hurdles unless underwriting banks can get a better handle on valuations. Historically, 80% of CRE loans are successfully refinanced; Chen said that could fall to 60%, risking a downward valuation spiral should there be significant foreclosures.

Lenders have traditionally sought to negotiate loan modifications, Chen said, adding that during the last housing crisis, 67% of troubled loans were modified, benefiting lenders and borrowers alike.

Loan modifications, however, are a temporary solution for buildings that are unlikely to regain their value. Yalamanchili said that some office buildings may be repurposed as residential, but many are unsuitable, and regulations can be an obstacle. In addition, companies’ smaller real estate footprints are saving them money. Some now require employees to reserve desk space before coming into their more constrained spaces.

“The office sector will be challenging in the months and years to come,” he said. “Eventually there has to be some kind of reckoning.”

How that plays out will vary by property type and region. Trophy Class A buildings, such as the One Vanderbilt tower next to New York’s Grand Central Terminal, have 8% to 10% vacancy rates, according to Mark Bhasin, senior vice president at Basis Investment Group and an adjunct associate professor at the NYU Stern School of Business. Those rates more than double for commodity Class A buildings without restaurants and other amenities, and Classes B and C buildings, which were typically built before 2005.

Multifamily housing has also taken hits due to overbuilding, especially in Sunbelt markets, as well as higher interest rates and slowing rental growth. Those factors, however, are largely cyclical, and demand for housing is high, so multifamily is anticipated to recover sooner than office and retail.

“In the U.S., the biggest portions of investors’ portfolios are office buildings and retail malls. Ironically, those are the two property types no one likes today,” Bhasin said.

Identifiable Opportunities

CRE segments such as warehouses, data centers and industrial properties are currently performing well. More challenged office and retail categories are bifurcated such that investors with available capital can selectively identify properties with some upside.

Suburban office buildings are faring better than those in urban cores, as are smaller shopping centers anchored by supermarkets and pharmacies when compared to larger malls. Medical offices “may offer some better opportunities because demand is likely to be stable and constant,” deRitis said.

Chen said an attractive residential investment is Fannie Mae and Freddie Mac credit risk transfer (CRT) bonds with coupons between 8% and 11%, and returns year-to-date between 15% and 18%. The bonds’ floating rate is a boon for investors who see high interest rates lingering.

AAA-rated CMBS can be favorable for investors who do the necessary analysis. “They have a significant credit cushion, and at the same time you’re taking advantage of a lot of bad news that is already priced in,” Chen said

Yalamanchili agreed that opportunities are emerging, given that real estate risk has largely been priced in at the macro, if not the individual property or bond, level.

“There probably isn’t any upside to selling currently, and I certainly would start looking to add incrementally at these levels,” he said.