US commercial real estate: expecting prolonged challenges

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Our outlook is based on many factors. First, CRE stress preceded the recent turmoil in the banking sector and represents more fundamental long-term changes in demand. The office segment (32% of the CRE sector3 has faced secular shifts, particularly from work-from-home trends, which lifted the US office vacancy rate to a record high of 18.2% in the fourth quarter of 2022.4 The retail segment (18%) struggled long before the pandemic due to structural changes tied to the e-commerce boom. Retail will continue to face long-term, but not new, cash-flow and geographic pressures. In contrast, the industrial segment (20%) has actually benefitted from the pandemic-driven surge in goods demand. In Europe, meanwhile, office demand is relatively stronger than the US. The average vacancy rate is less than 8%5, while leasing activity rose 14% year-on-year in 2022 and office take-up rose 2% above the pre-pandemic average.6

Maturity risk for pressured CRE segments in 2023 is less acute than in the global financial crisis. Banks hold 45% of debt in the USD 4.5 trillion CRE mortgage market, but offices represent just 17% of income-producing property loans relative to 44% for the multi-family sector.7 Offices account for less than USD 100 billion of debt repayments due this year, even though a ramp-up in maturing debt in future years will likely lead to more sector defaults and increase loss severities over the medium term.

While we expect moderate increases in defaults, the workout period will be lengthy, and lenders will likely also pursue loan modifications with challenged borrowers dampening some of the negative impact. Loan-to-value ratios for loans range from 50-55% while debt-service coverage ratios are conservative, providing material cushion. Longer loan terms of typically 5- to 10-years also reduce maturity default risk, and maximizing value through liquidations and restructuring can take several years. That said, increased property supply, higher financing costs and available reinvestment alternatives may increase incentives to foreclose on a property, especially in lower-quality segments. Any further liquidity stresses faced by banks or a deeper US recession would also pressure CRE valuations. While loan losses will depend heavily on the transaction, average loan-to-value ratios imply a 40-50% decline in values before losses are taken.7

Insurers face less immediate pressure than small banks given a lack of deposit risk, a larger weight toward higher-quality CRE mortgages and securities, a lower overall CRE weight in investment portfolios, and positioning towards less-affected segments such as residential. In the US, only 36% of annuity liabilities can be withdrawn by policyholders without penalty, and P&C liabilities are run proof. In statutory filings at 2022, life insurers held USD 668 billion of mortgage loans and P&C insurers just USD 28 billion. That’s 13% and 1% of their respective investment portfolios, compared to 24% of US banks’ lending (see Figure 2). Adding direct real estate holdings brings the portfolio shares to 14% and 2%. Insurer investment exposure to office is estimated at 21%, 11 ppt below the national share, and at 29% for the relatively strong multi-family segment.8 Insurance exposures are also well-diversified across property types and geographies. This suggests a broad-based CRE downturn poses less solvency risk to most insurers than to banks.

Figure 2: US insurers have relatively lower CRE exposure

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