Are we heading for a commercial property crash?

The pandemic has reduced the demand for office spaces and permanently changed the office environment. But John Stepek says rising interest rates are a bigger threat to commercial property right now.

We’re still getting to grips with the after-effects of the last two and a half years of the pandemic and the lockdowns. 

One thing that appears to have changed permanently is the office environment. I’m going to get anecdotal here but I think it’s reflective of the wider experience in many offices. 

I live in Kent within the ever-widening commuter belt. Before the pandemic, I worked one day a week from home. During the pandemic it was permanently at home. Now it’s three days in the office, and two days at home. 

Two things are very clear purely from observation. One is that Tuesday to Thursday are the “peak” office days. The station car park is maybe half-full on a Monday or Friday. It’s rammed the other three days. 

The other is that flexibility generally has increased. Heatwave? Work from home. Maybe-covid, maybe-not sniffle? Work from home.

Companies still need office spaces. And a lot of them have rented out office space for long periods. But they definitely don’t need as much of it as they once did. And you also have to wonder about how expanding companies might be looking at office space too. 

Where’s the demand? How can it grow as fast as it once did? And what happens once long-term leases start to come up for renewal? 

The biggest problem facing commercial property today

But that’s probably not commercial property's biggest problem right now. The biggest issue today is exactly the same as the problem facing the residential property market – interest rates are going up. 

Put very simply, property is valued based on the yield you need to get from it as an investor. What might that number be? Well, as with every other asset, it’s relative. If you can get 5% from a bank account, you are not going to ask for anything less from owning a property. And given that a property is much riskier (you can’t sell it quickly and the folk who rent from you might not pay their bills), you’re going to ask for a good bit more than 5%. 

As a result, if interest rates go up across the wider economy, then as an investor, you are going to be willing to pay less for a given sum of rent. In other words, you won’t pay as much for a given property.

There’s another risk too. Rising interest rates combined with the surging cost of living are making everyone worry about recession. Even a mild recession means investment in property will likely dry up, rents will come under pressure – in all, it’s not a cheerful outlook.

The thing is, this doesn’t necessarily mean disaster for every part of the commercial property market. Some areas are more expensive than others, and some sectors face more challenges than others. My colleague David J Stevenson looked at this in more detail a couple of months ago. 

Could a commercial property crash batter the banks?

What about a wider crisis? 

Classically, the big problem with commercial property is what happens when loans start going bad. In the past, we’ve seen banking crises kicked off by downturns in the commercial property sector. The banks end up being over-exposed to the sector and as a result they rein in lending to everyone else, and you end up with something not dissimilar in nature (though different in scale) to the 2008 financial crisis.  

The good news on that score, notes Matthew Pointon of Capital Economics, is that “lending exposure to commercial property remains modest by past standards.” That in turn “will limit the risk of a commercial property downturn triggering a banking crisis.” 

And the reality is that this is not proving to be a straightforward business cycle. Some sectors of the economy are likely to remain in good health. 

From an individual investor’s point of view, what’s the upshot? To me, it’s not so much about blanket avoiding commercial property. It’s more about being aware of how you invest in it. 

If you are investing in commercial property, make sure you’re doing it through a real estate investment trust (Reit) rather than through an open-ended property fund. 

If there’s a crash in the sector, the risk with an open-ended property fund is that you won’t be able to get your money out in a hurry. We saw this happen with Brexit and we’ve seen it happen on occasion since. I suspect if you’re a long-term MoneyWeek reader you already know this, but it’s worth reiterating – there’s no benefit to being in an open-ended fund for this sort of illiquid investment. 
My colleague Rupert gave his view on some of the most interesting Reits out there right now in a recent issue of MoneyWeek magazine. You can read the piece here.

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