As 2023 came to a close the European Central Bank (ECB) predicted that the euro zone's sinking commercial property sector could struggle for years to come, posing a threat to the banks and investors that financed it. We consider the causes and symptoms of the distress in the Irish commercial real estate (CRE) market, the lessons that can be learnt from the US and UK, and whether a further repricing of the market is likely. We will also examine the potential catalysts in bringing about a market correction and the investment opportunities that will result.
Current state of the Irish CRE market
Rising funding costs, tightening credit standards and a deterioration in sentiment amongst market participants have caused investment activity in the Irish CRE sector to decrease. This slow down stood at nearly 60% by the end of the third quarter of 2023 compared to the same period in 2022. This has been accompanied by a sharp decline in property capital values, down 14% year-on-year according to 2023 Q3 data from the Central Bank of Ireland, bringing the cumulative fall to over 20% since late 2019. As of the time of writing, the Central Bank of Ireland has not yet published its year end data, but it is predicted the CRE investment activity in 2023 will be significantly below the 10-year average.
The office sector is currently the worst performing, with the largest price declines for lower quality, older and less energy efficient units. While rising interest rates have put downward pressure on prices in the Irish CRE market, waning tenant demand due to remote working policies and a change in Irish tech firms’ office requirements, has also played a significant role. CBRE report that the vacancy rate across all stock in the Dublin office market is now close to 15%, this is the highest point since 2014.
On the finance side, lenders are reporting sizeable movement of CRE loans to stage 2 arrears. This is defined under accounting standards as a significant increase in credit risk. One bank’s half year results reported an increase of stage 2 loans from €2.3 billion to €3.7 billion in its property and construction portfolio, excluding residential mortgages. €1.6 billion of this was made up of commercial investment exposures, most of which were commercial investment office loans. For context, the bank cited potential interest cover breaches and an unlikelihood of these borrowers being able to meet refinance terms as causes of this movement.
On a more positive note, the Central Bank has recently reported that Irish banks’ CRE exposures are a much smaller portion of total lending than in the past. They had declined significantly since the 2008 financial crisis from just over 30% to under 10%. CRE borrowers now have loan-to-value (LTV) ratios that will allow for substantial price declines before losses are experienced, with the estimated weighted average current LTV of banks’ CRE investment exposures currently around 50%. However, the Central Bank now warns that LTV positions are subject to elevated risks relating to market liquidity when trying to realise collateral values in a stressed market.
Comparisons with the US and UK CRE markets
Distress in the commercial real estate market is not unique to Ireland. Globally, commercial property investment is at an all-time low. This is largely driven by the same factors: high interest rates and waning demand for office space. Despite this, there has not yet been a significant repricing of the CRE market. Sources indicate that in the 12 months up to the end of March 2023, US-listed real estate prices decreased by 14%, compared to 22% in the UK for the same period and 13% in Europe.
Some of the reasons for this are:
- Assets being refinanced rather than repriced and sold, and
- Lack of willingness from sellers to accept low offers, particularly in London where purchasers are seeking to pay over a quarter below the asking price
As with the UK and US markets, there remains unrealistic pricing in the Irish CRE sector. There needs to be a cyclical pricing correction in weaker CRE assets to bring liquidity back to the market.
Opportunities and solutions
While it is clear the Irish CRE market is in need of further repricing, we must look to the potential solutions in making that happen, and whether they are likely to be borrower-led or lender-led.
The price gap between sellers and purchasers can, at least in part, be explained by timing of loan maturities and the “pretend and extend” phenomenon. The Central Bank reported in its most recent Quarterly Financial Stability Review that most commercial real estate loans owed to banks need to be repaid or refinanced by 2027, with a quarter due by the end of 2024. Despite this, the prevalent attitude among market participants is “survive to 2025”. We should expect to see extensions, modifications and a variety of other tactics as lenders and borrowers “hold-on” in the hope of “waiting- out” the high interest rates and for market conditions to improve. In the current market, enforcement makes little sense to lenders who will be hard-pressed to get more out of these assets than the current owners. However, if lenders are unwilling or unable to extend new credit or refinance the existing loans, owners will be forced to align their pricing to make assets more attractive.
As the traditional banks look to keep their LTV and Non-Performing Exposure (NPE) ratios in line with ECB requirements, many CRE loans will be unable to refinance without creative solutions from borrowers and alternative lenders. KPMG’s recent Irish Real Estate Lending Survey paints a picture of the difference in attitude between senior banks and non-bank lenders regarding appetite for risk. In terms of lending for office projects, 50% of senior banks said that they would lend at an LTV ratio of up to 59%, while 50% would lend at an LTV ratio of up to 69%. When non-bank lenders were asked the same question, a third said they would lend at an LTV ratio of up to 69% and 44% said they would lend at an LTV ratio of up to 79%.
The conservative approach of the traditional banks will require borrower-led resolutions. These might include:
- An injection of additional sponsor equity
- Putting in place hedging agreements to safeguard against interest rate rises, and
- Consensual sales
This kind of creative capital structuring may plug the gap until interest rates start to level out.
The ECB restrictions on the traditional banks have resulted in a widening of the debt-funding gap. It is defined as the gap to be bridged between the original debt amount due at loan maturity and new debt available to repay the original debt. The debt-funding gap presents an opportunity for lender-led resolutions in the form of investment by alternative lenders, as demand for alternative financing grows. Alternative financing solutions include additional sponsor equity, mezzanine and junior debt insertions and preferred equity lending, or a combination of these. Indeed, we are aware of private equity credit funds being set up for this purpose.
If refinancing is not achievable, and owners do not elect to put their properties back on the market, an orderly sale of loans on a consensual basis with sponsors is the most likely course of action for banks as they look to protect their balance sheets. This approach is prevalent in the US market at the moment. This presents another opportunity for investors to purchase portfolios of non-performing loans or loans experiencing stress at a discount. Alternatively, investors experienced in asset restructurings may adopt a loan-to-own strategy and acquire discounted, non-performing debt to lead a restructuring, becoming the equity owner of a property at a discounted valuation.
Receivership is an important tool for lenders if a borrower enters repayment difficulty. The Beckett Building formerly occupied by Meta is a recent high-profile example of a Dublin office put into receivership. Bought by Korea-based Kookmin Bank for €104 million, it was put back on the market at a significantly reduced price of €80 million. Even at €80 million, the owners were unable to find traction for a sale and, reportedly, the lender was in a position to accept an offer as low as €60 million.
The repossession and potential sale of CRE assets by lenders has the potential to exacerbate price declines. Receivership numbers remain low. From the stock of outstanding balances owed by Irish CRE borrowers in June 2023, just 0.1 per cent of these balances are associated with a receivership initiation in 2023. This is broadly in line with an average of 0.2 per cent for the years 2020 to 2022, which suggests this trend is set to continue in the near term at least.
Despite economists predicting cuts by Q2 2024, ECB interest rates remain stubbornly high and with Eurozone inflation rising again in December 2023, the economic outlook remains uncertain.
If we do not see interest rates tapering off from Q2 2024 onwards, traditional lenders may be forced to take more aggressive action against borrowers in an effort to protect their balance sheets. This may come in the form of loan portfolio sales. Of course, these sales will offer an alternative entry point for investors and will also open the door to loan-to-own strategies. We may also see increased levels of receiver sales if lenders decide to enforce.
Movement in the CRE market may be triggered if traditional lenders lose confidence in the value of CRE loans and borrowers’ resilience wanes in the current market conditions. If borrowers cannot refinance with the traditional lenders, they may look to alternative lenders with strong balance sheets to offer equity top-ups and other forms of alternative financing to help bridge the debt funding gap. While market participants have adopted the “survive to 2025” mantra, 2025 may seem a long way away for those borrowers due to refinance during 2024.
For more information and expert advice on navigating the issues impacting the CRE market in 2024, contact a member of our Financial Services team.
The content of this article is provided for information purposes only and does not constitute legal or other advice.