The economic recovery continues at a robust pace, the search for yield continues and house prices keep going up. Against this backdrop, it is important not to lose sight of growing vulnerabilities and risks to financial stability.Read more
The impact of the pandemic on the commercial real estate market
Commercial real estate prices may slide in the coming period, not only as a result of the coronavirus crisis and the lockdown restrictions, but also due to structural trends such as online shopping and remote working, both of which have accelerated since the outbreak of the pandemic. The effects could prove to be of a more permanent nature, particularly affecting prices for office and retail buildings.
Commercial real estate (CRE) prices generally have a lagged response to economic changes. The marketability of properties (market liquidity) tends to respond more quickly to shocks and is therefore an indicator for price developments. A shock in market liquidity reflects market perceptions of all economic changes over a specific period, including expenses associated with changing property requirements as a consequence of the coronavirus pandemic – for example if hybrid working becomes more popular. CRE market liquidity has fallen sharply since the outbreak of the coronavirus pandemic. The drop in the first three quarters of 2020 was approximately 28%. The market liquidity measure is based on the likelihood of a transaction and price developments. It is described in more detail in the Dutch-language article. Market liquidity dropped by approximately 46% during the 2008-2009 financial crisis. It should be noted that the 2020 decline took place far more rapidly. In comparison, the drop in market liquidity during the first three months of the financial crisis was approximately 20% (see Figure 1).
Figure 1: Trends in CRE prices and market liquidity in the Randstad.
Source: Real Capital Analytics; Van Dijk, Kinsella Thompson & Geltner (2021)
Possible price correction
Prices in the private CRE market continued to rise in the first three quarters of 2020 (see Figure 1). In the past, market liquidity used to drop both more sharply and sooner than prices. Extrapolation from this past relationship between market liquidity and price developments makes it possible to estimate future price effects. This indicates a negative price correction of 25% on average, with a bandwidth between 11% and 34%. This is a substantial price correction, but it is smaller than during the financial crisis. The price correction based on market liquidity is also close to the decline seen in listed real estate in 2020. The average price of Dutch listed CRE declined by approximately 35% in 2020, according to the European Public Real Estate Association. The price dynamics of listed CRE are ahead of those of private CRE, but tend to react too strongly to severe market shocks (overshooting). Moreover, the composition of private CRE (retail, offices, apartments) is different from that of listed CRE and has a different leverage.
The price correction is likely to occur mainly in office and retail real estate due to structural trend shifts to online shopping and remote working. It is important to note that the assumed correlation between market liquidity and price developments is based on past developments, and that the current situation is different. For example, government support packages are in place to prevent tenants from getting into acute financial difficulties, possibly enabling property owners to ‘ride out the crisis’ and not have to resort to forced sales. And there are other trends not directly related to the coronavirus crisis that could also affect CRE price developments. For example, changed sustainability requirements could have a significant impact on the value of non-sustainable office buildings. In 2023, all office buildings are required to have a level C energy label or higher.
A decline in CRE prices could affect the soundness of financial institutions. Our spring 2021 Financial Stability Report will therefore include the results of a stress test involving the effects of a sharp decline in commercial real estate prices on the balance sheet positions of financial institutions.