European Commercial Real Estate Values May Fall Up To 40%

Real estate companies, already among Europe’s worst performers this year, look set for more pain as rising interest rates fuel a surge in financing costs while investors’ concerns about the outlook for commercial property developers grow.

Sweden’s property stocks — seen as forerunners for the troubles facing European real estate — have been slumping this week as SBB, one of the country’s biggest commercial landlords, halted dividends and canceled a rights issue after suffering a debt ratings cut. That’s bad news for the Stoxx 600 Real Estate Index, which has erased about €140 billion ($154 billion) in market value since a peak in August 2021, down 45%.

Citi analyst Aaron Guy estimates commercial real estate asset value in western Europe could fall by up to 40%, which could potentially trigger covenant breaches and require as much as €178 billion of new equity or “other mitigating actions.” That’s more than the entire real estate sector index’s market cap of €144 billion.

Covenant risks, along with the refinancing profile of real estate to lower loan-to-value ratios, require a “significant re-equitization” in the sector, says Citi’s Guy. That implies potential downside in the near term, but may offer a medium-term opportunity, he adds.

The rates-sensitive sector also remains under pressure after the European Central Bank last week said its hiking campaign has more to go, with some officials pushing back against market assumptions that the cycle will end in July. Amid worsening sentiment, strategists at Barclays and JPMorgan are among those bearish on the sector. 

“Higher rates means lower valuation and could lead to rights issues,” say Barclays strategists, who are underweight the sector, viewing it as a bond proxy. Stocks are also challenged by a structural shift to work-from-home trend, as well as retail digitalization, they add. JPMorgan strategists are also underweight, given poor fundamentals, although they note stalling bond yields may offer some respite.

Their peers at Bank of America are more optimistic, saying expectations of lower bond yields as recession bites is a reason to be overweight real estate this year.

Risks loom largest over Swedish real estate, which enjoyed high growth fueled by historically low interest rates in the past decade. Now, the market has more than $40 billion in bonds maturing in the next five years, a quarter of which falls due in 2023. Much of that debt is short term and floating rate, making it particularly exposed to rates.

Adding to concerns, many of those firms have complex shareholding structures, often overlapping between several listed firms, where one margin call has the potential to set off a chain reaction.

While the risk of SBB’s current woes spreading to other major Swedish landlords is not tremendous, the dividend halt and scrapped rights issue will be “yet another negative overhang for the sector,” says Molly Guggenheimer, equity strategist at Danske Bank.