Property is the victim not the villain this time - Capital Economics
US Commercial Property

Property is the victim not the villain this time

US Commercial Property Update
Written by Andrew Burrell

Property has generally been at the centre of the most severe economic downturns in recent decades. But this time it is different. Although we think the commercial market is likely to experience a sharp jolt in 2020, provided the spread of the virus can be controlled, it should avoid the steep downturns of the past.

  • Property has generally been at the centre of the most severe economic downturns in recent decades. But this time it is different. Although we think the commercial market is likely to experience a sharp jolt in 2020, provided the spread of the virus can be controlled, it should avoid the steep downturns of the past.
  • Not long ago, our Global Economics team wrote a Focus (Why is property so often the source of trouble?) highlighting the key role of property in past recessions. It noted that this largely reflected the sector’s size and its inherent cyclicality. The value of the property stock (particularly residential) is vast, about half as large again as global GDP and so when things go wrong they have macroeconomic consequences. Property also tends to be highly cyclical although the degree does vary widely between markets.
  • Of course, property remains cyclical and may be centre stage again in future downturns, but it has so far kept a lower profile in the current crisis. This in part reflects its unusually sudden onset. The crashes of 2008 and the early 1990s were fomented during lengthy economic expansions at times of easy credit. This environment supported a surge in property leasing, investment and building over a period of years. By contrast, COVID-19 was unknown before the start of 2020.
  • Moreover, borrowing secured on real estate was a root cause of the 2007-08 financial crash. Rising property prices and plentiful liquidity spurred soaring bank debt. When credit markets seized up in 2007, yields began to rise and when occupier demand collapsed, banks, already reeling from the sub-prime crisis, took a further hit. A deep recession and property crash soon followed.
  • This direct transmission from property to economy via bank borrowing is absent this time. UK and US real estate lending have certainly not recovered since the GFC. Also, loan-to-value ratios are significantly lower than at the peak of the 2000s boom in all global regions. (See Chart 1.) This is a legacy of the last crisis on bank balance sheets and shows their very cautious approach to property in the latest cycle.
  • This lack of debt is also evident in the subdued property development cycle seen in most developed markets. US data show that completions in the office market have declined sharply relative to both early-2000s and pre-GFC peaks. (See Chart 2.) Unlike previous crises, tighter supply will help insulate vacancy against the inevitable collapse in demand during Q2 and provide some support for rents until it recovers.
  • Finally, while there remain concerns about the low levels of nominal property yields, valuations indicate that property has remained close to fair value in most commercial markets. Admittedly, this is a relative measure and there has been much turbulence on financial markets over recent weeks. But the comparison with the GFC, before which real estate assets had looked over-valued for some time, provides some comfort. (See Chart 3.)
  • These mitigating factors explain the less severe property outlook. In 2008-09, capital values fell by over 20% globally, with the worst hit markets – the US and UK – experiencing a drop closer to 40% peak-to-trough. (See Chart 4.) The subsequent recovery was also slow, with values taking over five years to reach their pre-crisis highs. This time, we expect the decline will be closer to 10% globally and values should also experience a rebound in 2021 that would make good the lost growth.
  • This profile also reflects the unique nature of this crisis and its impact on real estate. Because the direct market is relatively slow moving, we do not expect the sort of correction we have seen in equities. Physical restrictions will halt investment and valuation activity over the coming weeks. This will curb forced selling and a lack of liquidity will make it near impossible to gauge pricing in Q2. By the autumn, yield pressures should be easing as life returns to near normal. We think peak yield increases will be around 50bp across markets and we also expect a half of this to be unwound by year end.
  • This health crisis has also provoked unprecedented government support to alleviate stress on businesses. Measures vary between markets, but the net impact is to support the ability of occupiers to pay rents and limit defaults this time. Of course, there will be pressure on rents during the worst of the crisis and the most exposed landlords will still be at risk. We expect rental falls of up to 5% this year depending on the sector and market, but growth is expected to revive quickly in the following quarters.
  • Nonetheless, all the risks currently lie on the downside. We remain unsure of the length and duration of the downturn and can’t tell yet if the output loss will be permanent or temporary. (See our Global Update.) For real estate, a longer lockdown would mean higher yields and lower rents, so inevitably values would fall further. But it should also be recalled that the GFC contraction lasted about two years in property, significantly longer than most expect the COVID-19 disruption to last.
  • In summary, capital values will correct in 2020 and returns will be negative in most developed markets, though there is reasonable hope that this will be reversed next year. But while commercial property is not expected to play the same role as in previous slumps, it will also not be immune to any further downside risks that emerge should the economic consequences be worse than we currently expect.

Chart 1: Average LTV Ratio by Region (%)

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Chart 2: US Office Completions (% of stock)

Chart 3: US All-Property Valuation Score

Chart 4: Global Capital Values (Cyclical peak=100)

Sources: PGIM, Refinitiv, MSCI, Capital Economics

Andrew Burrell, Chief Property Economist, +44 7958 902 151,


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