Is commercial property the ‘next shoe to drop’?

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This is an audio transcript of the FT News Briefing podcast episode: ‘Is commercial property the “next shoe to drop”?’

Marc Filippino
Good morning from the Financial Times. Today is Tuesday, May 9th, and this is your FT News Briefing.

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A lot of folks are expecting the Bank of England to raise interest rates again this week. And China is being blocked out of European deals. Plus, US commercial real estate could be the next shoe to drop.

Ortenca Aliaj
You don’t know where these pockets of trouble are going to turn up. And being caught off guard is pretty much the worst thing.

Marc Filippino
I’m Marc Filippino and here’s the news you need to start your day.

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British central bankers gather later this week and they’re expected to raise interest rates for the 12th consecutive time. Behind the expected move from the Bank of England is, of course, stubbornly high inflation. Official data for March showed inflation running at over 10 per cent, well above what the BoE forecasted earlier this year. Now the question is how much the Bank of England will raise rates. Economists in the markets almost universally expect a quarter of a percentage point rise. That would bring rates up to four and a half per cent, the highest level since 2008.

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Chinese investment in Europe fell last year to its lowest point in almost a decade. A new study examined 16 deals in 2022 involving Chinese entities buying European businesses. Ten out of the 16 were not completed, in part because of regulatory concerns. Here’s the FT’s global China editor, James Kynge.

James Kynge
Europe has begun to vet Chinese inward investments quite a bit more carefully. And I think that has been responsible for quite a few big deals in rather sensitive high technology areas or critical infrastructure areas not going ahead. There has been a couple of semiconductor deals, acquisitions by Chinese companies in Germany that didn’t go ahead after the German government exercised its scrutiny over those deals. It’s not that every deal has been expressly blocked by European regulators. Some of them have been blocked, others have been deferred. The others, regulators in Europe imposed so many stipulations that the deal just collapsed.

Marc Filippino
So, James, what industries are being hit hardest by Europe’s stricter regulations?

James Kynge
Where most of the slowdown has come actually is in mergers and acquisitions. The Chinese had been big investors through acquiring European companies, but because of this increase in regulatory security and also the capital controls from China, this has really fallen off a cliff. The area which has not been hit so badly is greenfield investments in Europe. Probably the biggest, the hottest area in that regard has been electric vehicles and particularly batteries. Some of the big Chinese battery makers, like CATL, have announced a big investment in Hungary. But not only that, in other parts of Europe as well. So if there is one area that remains fairly hot, it is that electric vehicle supply chain area.

Marc Filippino
But for the industries that it is affecting, I have to assume that this type of clampdown isn’t gonna stop anytime soon, right?

James Kynge
A lot of people in Europe think that the opposite will happen. That is, that more countries are coming up with their own tightened regulatory regimes with regard to inflows of foreign investment and particularly Chinese investment. So the authors of this report, they think the intensification of scrutiny by regulators throughout Europe is only going to increase.

Marc Filippino
James Kynge is the FT’s global China editor.

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Analysts and investors are warning that the current turmoil surrounding US regional banks could give way to a crisis in US commercial real estate. This is a $5.6tn market, and it’s being strained by rising interest rates and falling demand for office space. A lot of us are still working from home because of the pandemic. To find out more, I’m joined by the FT’s mergers and acquisitions correspondent, Ortenca Aliaj. Hey, Ortenca.

Ortenca Aliaj
Hi.

Marc Filippino
So there’s a great quote in your story from the co-president of the private equity firm Apollo. And he says, “Commercial real estate is the next shoe to drop.” What did he mean by that?

Ortenca Aliaj
Last week, me and my colleagues were at the Milken Conference in Los Angeles. And this is really all that most people are talking about. The failure of three regional banks has gotten people slightly worried about commercial real estate because regional banks are by far the biggest lenders for real estate. And if they start pulling back on lending, it creates problems for developers in the next few years. A lot of the loans that developers and property owners have taken out are going to mature and they’re going to need to refinance or get more capital. And if the regional banking sector isn’t there for that, that’s gonna be a bit of a problem for CRE.

Marc Filippino
CRE being commercial real estate. And one of the things feeding into this concern is higher interest rates. The Fed’s raising rates to fight inflation, but how do those higher interest rates hurt the commercial real estate market? Can you draw me a line from A to B?

Ortenca Aliaj
Well, so you’ve had 10 years where you could get loans at pretty much zero interest rates or just above zero. And now the rate rises mean that you basically have to pay more money for borrowing cash. And that doesn’t work very well, especially when you’re in a market where there are declining property valuations. So you’re effectively refinancing or borrowing at a higher rate. And this tends to sort of squeeze the property market.

Marc Filippino
Do you have a sense of how severe the problem is or how bad it could get?

Ortenca Aliaj
So this is yeah, this is the problem with commercial real estate is that there’s not comprehensive data to show how well the loans are performing or what the occupancy rates are. So there’s just a level of uncertainty about how bad it will be and two sides to it. Some people are extremely worried and they don’t want to underestimate the risks. And some people are a little bit more relaxed and think that people are overreacting.

Marc Filippino
Worst-case scenario, I mean, what are we looking at here?

Ortenca Aliaj
I think what describes it best is one of the quotes in our story from a banking chief executive who basically says the greatest risk is you don’t know where the leverage sits.

Marc Filippino
Leverage, meaning loans that you’ve taken out.

Ortenca Aliaj
Exactly.

Marc Filippino
To spend on other things, right?

Ortenca Aliaj
Exactly. Exactly. So you don’t know where these pockets of trouble are going to turn up. And being caught off guard is pretty much the worst thing. I think that’s probably what investors are thinking now. I mean, who could have predicted three or four months ago that we would have this “regional banking crisis”? People now are just much, much more cautious and they want to rein in risk.

Marc Filippino
Ortenca Aliaj is the FT’s mergers and acquisitions correspondent. Thanks, Ortenca.

Ortenca Aliaj
Thank you.

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Marc Filippino
You can read more on all of these stories at FT.com. This has been your daily FT News Briefing. Make sure you check back tomorrow for the latest business news.

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