ECB study highlights firms’ exposure to property downturn

Investors with significant exposure to commercial real estate are especially vulnerable to a downturn in the sector, analysts from the European Central Bank have said.

In an article published on November 5, Pierce Daly, Ellen Ryan and Oscar Schwartz Blicke put the total value of the eurozone’s physical commercial real estate market at €2.7 trillion ($2.9 trillion).

Real estate companies (RECs) own the largest share of this at €1.1 trillion, followed by real estate investment funds (REIFs) at €526 billion, real estate investment trusts (REITs) at €266 billion, and insurance corporations and pensions funds at €108 billion. The remainder is owned by other investors both from inside and outside the eurozone.

The study says REIFs are particularly exposed to “liquidity mismatches”, which makes them vulnerable to a commercial real estate downturn. Commercial property makes up the majority of REIFs’ assets, and the funds have tripled in size over the past decade.

Large French and German REIFs have “substantial holdings of office properties”, which could expose them to losses arising from falling demand as employees increasingly shift to hybrid working arrangements.

The falling values of properties and forced sales could “further compound declines” in commercial real estate prices and liquidity. This, the authors say, could have a negative impact on the values of assets and collateral held by other classes of investor.

The authors say stresses in the commercial real estate sector could also have “cross-border implications”, as some of the largest REIFs from Germany and Luxembourg invest significantly in other countries in the eurozone. However, they add that “in the absence of detailed fund-level and portfolio-level data… it is not currently possible to assess the extent of the risks facing these funds, or the broader REIF sector”.

Some REIFs could face higher refinancing and debt servicing pressures as a result of higher interest rates, the authors say.

REITs and RECs are also vulnerable, the researchers say, but their vulnerabilities mainly stem from high leverage. Falling real estate prices could lessen their ability to absorb losses and refinance. This would be especially true for those REITs and RECs that rely on short-term and variable-rate financing.

Given their market footprint, stresses among REITs and RECs could have “significant consequences” in the underlying commercial real estate markets.

Insurance companies and pension funds are “not significantly exposed to commercial real estate” via direct ownership, the researchers say, as this only accounts for 1% of their total assets. For these types of investor, the main risks stem from larger losses resulting from indirect exposure to commercial real estate.