Bank Lending to the Commercial Real Estate Sector - a Source of Systemic Risk?

Hagen, Marius; Hjelseth, Ida Nervik; Solheim, Haakon; Vatne, Bjørn Helge Research Report Bank Lending to the Commercial Real Estate Sector - a Source of Systemic Risk? Staff Memo, No. 11/2018 Provided in Cooperation with: Norges Bank, Oslo Suggested Citation: Hagen, Marius; Hjelseth, Ida Nervik; Solheim, Haakon; Vatne, Bjørn Helge (2018) : Bank Lending to the Commercial Real Estate Sector - a Source of Systemic Risk?, Staff Memo, No. 11/2018, ISBN 978-82-8379-060-3, Norges Bank, Oslo, https://hdl.handle.net/11250/2581808 This Version is available at: https://hdl.handle.net/10419/210361 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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NO. 11 | 2018 Marius Hagen, Ida Nervik Hjelseth, Haakon Solheim and Bjørn Helge Vatne, Financial stability, Norges Bank NORGES BANK STAFF MEMO NO 11 | 2018 BANK LENDING TO THE COMMERCIAL REAL ESTATE SECTOR—A SOURCE OF SYSTEMIC RISK? Staff Memos present reports and documentation written by staff members and affiliates of Norges Bank, the central bank of Norway. Views and conclusions expressed in Staff Memos should not be taken to represent the views of Norges Bank. © 2019 Norges Bank The text may be quoted or referred to, provided that due acknowledgement is given to source. ISSN 1504-2596 (online) ISBN 978-82-8379-060-3 (online) Bank lending to the commercial real estate sector – a source of systemic risk? ∗ Marius Hagen, Ida Nervik Hjelseth, Haakon Solheim and Bjørn Helge Vatne Financial Stability. Norges Bank† January 15, 2019 Banks’ commercial real estate loans account for almost half of banks’ total loans to non-financial enterprises. Losses on these loans are normally low in good times, but they have proved to be one of the largest sources of bank losses in financial crises. As there is often a mismatch between the maturity of a bank’s commercial real estate loan and the lifetime of a property, there is a risk that banks do not adequately price in losses on commercial real estate loans incurred during crises. This article further argues that financial risk is particularly high in the office segment. Prices in Oslo are currently elevated, vacancy rates are low and construction in recent years has been limited. Structural factors are restraining speculative construction. A tight market on the supply side may contribute to reducing the risk of a substantial price adjustment even if yields should rise. 1 Introduction Commercial real estate (CRE) companies own and manage properties such as office or retail space, hotels and logistics facilities. Compared with other sectors, CRE sector debt is high relative to both operating revenue and earnings 1 (see box on next page for a description of how commercial real estate is defined). Banks are by far the most important source of external financing 2 , although bond debt has played a more important role in recent years. CRE lending is also important to banks. CRE loans account for almost half of the stock of bank lending to non-financial enterprises. As commercial real estate has historically been a main source of problems for banks during financial crises, it is important to understand when risk builds up in the CRE market. Commercial real estate prices have risen sharply in Oslo in recent years. As crises in the past have often occurred following periods of high commercial real estate price inflation, it is particularly important to monitor the CRE market now. This article discusses the risks posed by the commercial real estate market, possible sources of systemic risk in this market and some current market trends. ∗ Views and conclusions expressed in this article are our own and should not be taken to represent the views of Norges Bank. We would like to thank Henrik Borchgrevink, Nina Midthjell Larsson and Torbjørn Hægeland for useful comments and input. †Contact person Haakon Solheim 1Earnings are defined as ordinary profit before tax. 2 At the end of 2017, bank loans accounted for 88 percent and bond debt 12 percent of external financing. In 2013, the share of bond debt was 4 percent. 3 Commercial real estate Commercial real estate is classified in the national accounts under ”Real estate activities”. The sector comprises three subgroups: •Buying and selling of own real estate •Renting and operating of own or leased real estate •Real estate activities on a fee or contract basis The CRE sector is dominated by the leasing of properties such as office or retail space, hotels and logistics premises. As most property companies own the buildings that are leased out, the CRE sector is capital-intensive. Direct output a for the CRE sector in 2017 accounted for about 4 percent of total mainland output and more than 40 percent of the total bank and bond debt of non-financial enterprises. aOutput in the leasing segment will be dominated by the estimated rental value of the space. 2 Risk factors in the commercial real estate market There are generally two types of risk that can bankrupt a company: •Liquidity risk: A company is not able to pay running expenses •Solvency risk: A company has negative equity Owing to a combination of a high debt ratio, high capital intensity and property leasing, the income statements of CRE companies are dominated by (i) rental income, (ii) interest payments and (iii) changes in property values. A fall in rental income and/or higher interest payments will put pressure on the liquidity of these companies. If income falls at a certain interest rate level, flexibility in expenditure will be constrained by the high debt ratio. Write-downs, normally as a result of changes in property values, can cause substantial profit volatility. In the event of a sharp price fall, write-downs could potentially wipe out a firm’s equity (see box on page 11 for further details). As these companies are often limited liability companies, shareholders will have sound reasons to assess the basis for continued operation. Finally, there is risk associated with debt refinancing. This type of risk can be particularly critical for commercial real estate as the debt ratio is high in this sector and loan agreements are often short compared with the lifetime of the property. Interest rate risk Prior to the financial crisis, CRE debt grew more rapidly than operating revenue. The debt-to- revenue ratio has since remained stable at a higher level. Owing to high debt levels in this sector, CRE companies are sensitive to interest rate increases. Analyses conducted by Norges Bank show that a 1 percentage point interest rate increase would have weakened the earnings of CRE companies 4 in 2017 to the same extent as a three percent fall in operating revenue (Chart 1a, see also Norges Bank (2018)). For non-CRE sectors, a 1 percentage point interest rate increase only represents 0.1 percent of operating revenue. Enterprises with weak earnings are particularly sensitive to interest rate increases. Consolidated financial statements data 3 show that the share of CRE debt that was in CRE corporate groups with negative earnings has, on average, been slightly more than 20 percent (Chart 1b). The chart shows that the share of debt increases somewhat with interest rate increases of 1.0 and 2.5 percentage points. The increase becomes substantial when the interest rate is increased by 5 percentage points. Since debt has risen, CRE companies are now considerably more sensitive to substantial rises in interest rates than in the early 2000s. Interest rate sensitivity must be assessed in the light of industry-specific factors, such as the level of average operating margins, the extent of fixed-rate borrowing and the scope for price adjustments. Commercial real estate leases are typically long term and companies often opt for a fixed rate on some of their debt for the terms of these lease agreements. In terms of volume, about half of the bonds issued by CRE companies in recent years have been fixed rate bonds (Chart 1c), and volume-weighted average maturity has varied between six and nine years. Operating margins in the CRE sector are typically high in normal times. CRE companies may therefore be less vulnerable to interest rate increases than their high debt ratios would imply. With the current solid earnings in this sector, most CRE companies would likely have the capacity to adjust to a moderate increase in interest rates. However, if interest rates rise markedly and revenue falls, the risk of losses will increase substantially. Risks associated with different types of property The CRE market is dominated by firms leasing office or retail space, hotels and logistics premises. As the various segments differ, credit risk will also vary. A substantial share of banks’ exposure to the CRE market is to the office segment. Purchases and sales of office space normally account for a large share of the total volume of CRE transactions, and market values are relatively high since a sizeable share of the stock of office buildings is located in the cities (Akershus Eiendom AS (2018) and Hagen (2016)). Many of these buildings are in Oslo. According to private analysts, there is 50 percent more office space in Oslo than in Bergen, Trondheim and Stavanger combined. DNB has the highest share of the CRE lending market, at around 25 percent (Hagen (2016)). Office property accounts for about half of DNB’s exposure to commercial real estate (DNB Group (2018)). Much of the office property market is not owner-occupied, and the renter’s identity or brand is not normally associated with the building. Office property ownership is diverse, with a substantial share of financial investors, particularly in the city centres (Folketrygdfondet (2014)). Office rental rates are set when the lease agreement is signed and are only adjusted to market rates when a new agreement is signed. Once a lease agreement has been finalised, the landlord will normally receive a reliable income in the lease period. Risk during the lease period is the risk of the 3 Since debt and earnings for complex corporate group structures are split among several companies, we use financial statements showing the corporate group as a whole in exercises using information for individual companies. 5 Chart 1 (a) Net increase in interest expenses with a 1 percentage point increase in interest rates as a share of operating revenue. Percent. 2000 - 2017 0 1 2 3 4 0 1 2 3 4 2000 2002 2004 2006 2008 2010 2012 2014 2016 Commercial real estate Other mainland industries Source: Norges Bank (b) Share of debt in group companies in the CRE sector with negative earnings in the event of different interest rate increases. Percent. 2000 - 2017 0 20 40 60 80 100 0 20 40 60 80 100 2000 2003 2006 2009 2012 2015 Actual developments 1 percentage point increase 2.5 percentage point increase 5 percentage point increase Source: Norges Bank (c) Volume of bonds issued by CRE companies in the Norwegian bond market and the share issued at a fixed rate. In billions of NOK and as a percentage. 2013 - 2017 0% 20% 40% 60% 80% 100% 0 5 10 15 20 25 30 35 40 2013 2014 2015 2016 2017 Emission volum (left axis) Andel fastrente (right axis) Source: Stamdata (d) Real commercial real estate prices.1Index. 1998=100. 1983 Q1 - 2018 Q2 50 100 150 200 250 300 50 100 150 200 250 300 1983 1994 2005 2016 Crises Real prices on commercial real estate 1) Estimated real selling prices per square metre for prime office space in Oslo. Deflated by the GDP deflator for mainland Norway. Average selling price for the past four quarters. Sources: CBRE, Dagens Næringsliv, OPAK, Statistics Norway and Norges Bank renter’s bankruptcy. When the lease expires, risk will be associated with developments in market rental rates and vacancy rates. Rents in new leases are usually sensitive to the business cycle and relatively closely correlated with developments in employment. Companies with a varied lease length profile will be less vulnerable to falls in rents and higher vacancy rates. Centrally located properties are normally attractive because the risk of vacancy is low and these properties are perceived as highly liquid. Retail leasing is a large segment that includes shopping centres, large shops and retail premises in a property leased to a variety of renters. Ownership of shopping centres is concentrated, and a few investors own a substantial share of the total value of the property in this segment. For other retail leasing, ownership is more diverse (Folketrygdfondet (2014)). Retail leasing agreements differ from office leases in that the rent is often linked to the renter’s turnover, although a minimum rent 6 is usually specified (Investing in Norway (2018)). Turnover volatility can therefore directly affect the owner’s rental income. At the same time, it provides a buffer for the renter, reducing the probability of bankruptcy. Compared with the office segment, both owners and renters in the retail segment are more likely to remain in the same property. It often takes time for retailers to gain a foothold. If they relocate, there is a risk of losing customers temporarily. Owner and renter will therefore likely be more closely connected than is normally the case in the office segment. Retail property owners are more likely to be industrial investors than office property owners, who will normally be more focused on actively managing and developing the property. Recent years have seen strong growth in online retailing (Halvorsen (2018)). Retail chains such as Enklere Liv, Tilbords and Habitat have gone bankrupt. Many other well-known chains, such as Nille, Jernia and Power, have run into difficulties (UNION (2018b)). As a result of the sharp rise in online retailing, other retail chains could over time encounter difficulties and reduce demand for retail space. This could lead to a marked fall in market rental rates for retail premises. Even though this is a trend that should be expected by lenders and already priced into the mortgage contract, there is a risk that the decline in the retail trade sector will be more pronounced and lenders’ losses larger than they expect. Ownership in the hotel segment is dominated by a small number of investors. As in the retail segment, rents are often turnover-based subject to a lower limit (Investing in Norway (2018)). A few companies operate most of the hotels in Norway. In many cases, these operators also own the property. Relocating a hotel involves substantial costs, and considerable brand value is gained from remaining in the same property through downturns. As both renter and owner are likely to have a more long-term perspective than in the office segment, the owner may be more interested in retaining the property through bad times. This may reduce the risk of lending to the hotel segment. At the same time, with a turnover-based rent, rental income will fluctuate to a greater extent. In addition, owing to concentrated ownership in this segment, concentration risk is high. There are usually relatively few renters in large logistics premises, normally with large leases (UNION (2018b)). Logistics premises are to a great extent located alongside motorways in areas outside Oslo. Easier access to land than in the cities and short construction periods have contributed to keeping rents low. Warehouse and combination properties are typically rented by smaller companies. Growth in online retailing has resulted in higher demand for buildings for warehousing and distribution. In our overall assessment, risk is highest in the office segment because of the high percentage of financial investors in this segment and because owners and renters are less closely connected. In addition, banks are likely highly exposed to the office segment. Other types of commercial real estate are owned to a greater extent by industrial companies, which will probably dampen the systemic risk associated with vulnerability in periods of sharply falling property prices, as these companies invest with a view to longer-term management and ownership. At the same time, the strong growth in online retailing may generate challenges for commercial real estate further ahead, and concentration risk is high in the shopping centre and hotel segments. 7 Chart 2 (a) Yields on prime office space in Oslo less long-term interest rates 1 . Percent. 2000 Q1 - 2018 Q2 0 1 2 3 4 0 1 2 3 4 Yields adjusted for long-term interest rates Average 1) Ten-year government bond yields. Sources: CBRE, OECD and Norges Bank (b) Yields on prime office space in European cities less long-term interest rates1. Percent. 2018 Q2 0 50 000 100 000 150 000 200 000 250 000 300 000 350 000 0 50 000 100 000 150 000 200 000 250 000 300 000 350 000 2000 2004 2008 2012 2016 Oslo Akershus 1) Ten-year government bond yields. Sources: CBRE, OECD and Norges Bank (c) Completed commercial buildings1in Oslo and Akershus. In square metres. 2000 - 20182 0 100 000 200 000 300 000 400 000 500 000 600 000 700 000 800 000 0 100 000 200 000 300 000 400 000 500 000 600 000 700 000 800 000 2018 2019 2020 2021 2022 2023 0-500 m² 500-1000 m² 1000-5000 m² >5000 m² 1) Provided the following buildings are used for commercial purposes: office buildings, business premises, restaurants and buildings for overnight accommodation. 2) For 2018, square metres built by end-Q3 Source: Statistics Norway (d) Office lease agreements due to expire, by size. In square metres. At 2018 Q3 -80 -40 0 40 80 -80 -40 0 40 80 2000 2002 2004 2006 2008 2010 2012 2014 2016 10th percentile 25th percentile 50th percentile 75th percentile 90th percentile Source: Area statistics Risk of price falls Commercial real estate ownership is usually in the form of limited companies. Property is most often bought and sold as shares in these companies rather than in the form of the property itself. Commercial real estate sales are therefore not registered in the same way as residential property sales. Hence, there are no selling price indices specifically for commercial real estate. Transaction volumes for office space are high compared with the other segments, and a number of market participants produce forecasts for CRE yields in the office segment in Oslo. Implied selling prices can be estimated by dividing rental income at current market rates by the required rate of return (see Hagen (2016) for a detailed description). As detailed price statistics are not available, relatively little is known about developments in selling prices for hotels and large retail and logistics buildings. The remainder of this section will therefore primarily focus on the risk of corrections in selling prices for office buildings. In the historical experience of Norway and other countries, prices for office buildings have often risen substantially prior to a sharp fall. When a rapid rise in prices coincides with an increase in 8 on management and ownership, which will likely dampen systemic risk associated with divestment in periods of sharp falls in property prices. On the other hand, hotels and shopping centres are characterised by a small number of large owners, and concentration risk is therefore high. There is also a risk that rising online retailing will create challenges for retail property in the long term. The combination of vulnerability to common shocks and possible market failure emphasises the need for effective regulation. Regulation must ensure that risk is taken into account over a project’s entire lifetime, for example by giving weight to the lessons learned from the financial crisis when calculating risk weights and capital requirements. In addition, efforts should be made to avoid regulation which has the effect of rewarding short-term loan contracts in the CRE sector. 15 References Akershus Eiendom AS (2018). 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