Why the world should fear a commercial property crash

On both sides of the Atlantic, people have recently been acutely worried about how the banking system would cope with higher interest rates.

Yet last week’s decision by the Bank of England to raise interest rates by 0.25 percentage points hardly caused a stir. Why would it? The move had been widely expected.

But this doesn’t mean that we are now done with worries about how higher interest rates will affect the financial system.

The Bank of England apparently believes in what the markets have dubbed “immaculate disinflation”. According to its new forecast, the UK will now avoid recession and inflation will fall sharply to only 1pc in two years’ time.

The financial markets expect two more 0.25 percentage point increases in Bank Rate. If this is what happens, medium- and long-term interest rates shouldn’t turn a hair.

But if Bank Rate has to go above 5pc and/or stay at the higher level for longer than the markets currently expect, then gilt yields would rise, with knock-on effects on longer rates throughout the system, including fixed rate mortgages and the valuation yardsticks for commercial property.

Residential property commands much more popular attention than commercial. Understandably. People live in it and they either own a piece of this market or regularly pay through the nose in rent because they don’t. Moreover, the value of the residential property market is about 14 times the value of the commercial one, which covers shops and retail parks, offices and industrial assets.

And it is true that when higher interest rates have caused major problems in the economy, they have frequently shown up in the residential market. It was trouble in the American sub-prime mortgage market that set-off the Global Financial Crisis (GFC) of 2007-9.

In this country the GFC is associated with the failure of the mortgage lender Northern Rock. In the early ’90s, when interest rates were held at 15pc and the economy was sent into recession with unemployment soaring to more than 10pc, people lived through mortgage misery, including the experience of “negative equity”.

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Yet problems in the commercial property sector have also often brought major difficulties for the banking system on both sides of the Atlantic.

The usual way to measure value in this market is to compare the spread of the yield on commercial property over the yield on 10-year gilts. When the commercial property yield almost reached parity with the yield on 10-year gilts in 2007, this was a clear sign of trouble ahead.

Over the following two years, average commercial property prices fell by 42pc. Today, commercial property yields exceed gilt yields by 2.5pc. That is low by historical standards, but not that low.

As it is, commercial property values fell dramatically in the second half of last year, down by 18pc on average and by 26pc for industrials. This means that the overwhelming bulk of the necessary price adjustment is probably behind us.

Things look more exposed in America. The spread of commercial property yields over 10-year Treasuries (American gilts) is only 0.5pc. To return the spread to normal, average commercial property prices need to fall from peak to trough by about 22pc. So far, average prices have only dropped by about 7pc, leaving a large fall still to come.

Residential and commercial property are placed very differently with regard to long term structural factors. Because people apparently want more space as they become richer, it is normal for residential property prices to rise in real terms over time.

By contrast, businesses are constantly striving to reduce costs and that includes the amount of space they take up.

Moreover, the huge recent rise in our population due to substantial immigration, now reportedly running at almost 1 million a year, assures a constantly rising number of people needing residential property.

Since 2020 we have been living with the whole Working From Home (WFH) phenomenon. This has had opposite effects on residential and commercial property, increasing the demand for the former as people have wanted more space at home, while reducing demand for the latter since, on any given day, fewer people have attended the office.

WFH has potentially spelled a pretty grim picture for the office sector. And on top of that, there is a whole raft of environmental and regulatory impositions that will either bring massive refurbishment costs to owning office property or even make large swathes of the office sector unlettable.

Fortunately for the owners of office property, on WFH the tide appears to have turned. More people are deciding that WFH is not good for them, either personally or in regard to their careers.

Meanwhile, quite a few employers have started to crack down and insisted on more office attendance or even office attendance full time. Naturally, this trend doesn’t yet seem to have hit the public sector.

Moreover, although we naturally accept that a rising population underpins residential demand, we should acknowledge that it will also indirectly do the same for the demand for commercial property, covering all three sub-sectors, retail, office and industrial.

The upshot is that although it is difficult to see very rosy immediate prospects ahead for commercial property, neither do the prospects look dire. Moreover, UK banks have significantly reduced their exposure to the commercial property sector from about 12pc of all UK bank loans by value in 2009 to about 7pc now.

Accordingly, my suspicion is that the UK financial system is not going to suffer acutely as a result of weakness in the commercial property sector, although the US looks more exposed.

That said, markets and policy-makers are surely right to worry that, after such a long period of very low interest rates and easy money, as monetary policy tightens, then parts of the economy and financial system will get into trouble. But they are not necessarily the same parts that got into trouble before. The risks probably lie mainly elsewhere – perhaps in places that hardly figured in previous crises.

Roger Bootle is senior independent adviser to Capital Economics

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