Chart 1

Table 1

Commercial Real Estate Values Skyrocket As GDP Lags

To understand what drives these advance rates, we need to dig deeper into CRE, because changes in market values will affect how much CRE values can decline in stressed environments and, consequently, how much a property will then be worth.

European CRE is currently continuing its years-long trend in upward-only value changes--for some property types. While logistics properties and residential assets have been largely unphased by pandemic-related economic disruptions--or have even benefited from them--properties that depend more on social interaction, such as shopping centers and hotels, have felt the full force of lockdowns and social distancing and are now only slowly recovering from recent years of slower performance.

Nevertheless, most of the CRE sector has gained back any losses suffered as a result of the pandemic and is continuing its upward trend. This is evident in Green Street's Pan-European Commercial Real Estate Price Index (see chart 2).

Chart 2

Although market values are usually a strong indicator of overall macroeconomic health, it has not always been the case over the past decade. If we overlay the property price index with economic growth data from Eurostat and index it to show the difference in growth over this period, the outperformance of CRE relative to eurozone GDP becomes apparent (see chart 3). While interest rates have been relatively stable and European GDP has increased 11%, CRE prices have gone up by 15% over the same period. This divergence might lead to a price correction over time, in our view.

Chart 3

In general, GDP growth is one of the main drivers of CRE rents and interest rates affect property yields. Rents and yields in turn are two of the main components in asset values. When price trends are broken out by property type, a more nuanced picture emerges (see chart 4).

Chart 4

If we split the data into U.K. and non-U.K. properties, changes in real estate values become even more divergent, especially in the retail subsector. For example, in continental Europe, shopping center values have dropped close to 15% from pre-pandemic levels, whereas value declines for U.K. shopping centers can exceed 50%, as shown in our value index of those U.K. shopping centers backing CMBS transactions that we rate (see chart 5).

Chart 5

The S&P Value

What does this mean for CMBS ratings? As we discuss in our criteria, the S&P Value that we assign to a property in our ratings analysis is not a regularly evolving market value. Instead, we calculate a recovery value that is "through the cycle", meaning it is based on a normalized property-level cash flow, which we divide by a long-term average cap rate. The S&P Value, therefore, increases over time if market rents increase or vacancies fall. However, because we use long-average cap rates and minimum thresholds on factors like vacancy, the increases in S&P Value tend to be much slower than the increases in market values.

During the four-year period starting 2018, we rated 29 new European CMBS transactions and took rating actions on existing ratings 39 times, during which we have re-calculated our S&P Value. Chart 6 illustrates how the average S&P Value haircut--on aggregate for all property types and locations--has risen over time to 32.4% in 2021 from 27.0% in 2018.

We can further break this down by property type, exposing how the change in value haircut between market value and the S&P Value for the combined sectors of logistics, office, and mixed-use portfolios is widest, increasing 10 percentage points over the same period. At the same time, the combined value haircut for retail and hotel assets actually came down between 2018 and 2020, because the cap rates for these property types moved closer to their long-term average. The 2021 haircuts increased again because we anticipated further value declines but had not received updated external valuations yet at the time).

Chart 6

We have also separated the numbers by region. In continental Europe, our book of rated CMBS transactions since 2018 includes fewer retail and hotel properties when compared with the U.K., which is why the value haircuts show a steadier upward trend.

Chart 7

Recovery Rates Stable Against Market Values

The recovery rates against the S&P Value have remained relatively stable over the same period. These numbers are more influenced by loan size, total leverage, whether or not there is additional debt, presence of operating assets among the collateral, and amortization. The stability of these numbers shows that securitized CMBS loans have not become riskier over time solely based on the abovementioned factors. However, we believe that the increasing risk of asset price corrections should be reflected in lower leverage over time, which it is not--at least not when looking at the European CMBS market as a whole.

Chart 8

As mentioned above, given that asset prices appear to have decoupled from economic development, we believe there is an increasing risk of future value corrections, which we reflect in our lower expected relative recovery assumptions when compared with market values in all rating categories. For example, chart 9 shows how our average 'AAA' advance rate against market value has declined to 31.4% in 2021 from 34.0% in 2018. Similarly, our average expected 'BBB' recovery rate has declined to 54.5% from 60.1%.

Chart 9

All else being equal, ratings will be lower on new transactions with the same leverage as measured by the underlying assets' market value. For existing ratings, there will be no change from this development alone. We would not raise our ratings because the underlying assets' market values have increased, unless the rise in value stems from higher rental cash flows and we deem those to be sustainable. Conversely, the risk of any asset price correction is priced into our value haircuts via our adjustments to reported cash flows and our cap rates.

European CMBS Subsector Outlooks

There is currently no indication that rental values in logistics or multifamily residential prices should decline over the near future.

In the office segment however, the ongoing return-to-office trend will determine to what extent changing space requirements of office users may affect supply and demand characteristics for the European hubs. The expected increases in vacancy rates in cities like London and Paris have already materialized, while some smaller continental European cities are not feeling the same heat. We believe that office markets that rely more on public transport--generally the larger cities--will incentivize workers to work more from home, thereby reducing employers' office space needs. That said, rising construction costs as a result of building material price increases will likely lead to a slowing in new supply over the medium term, which may balance out some of these pressures on rental markets. Continuously high energy prices will likely exacerbate this as energy-intensive building materials become even more expensive.

Rising interest rates as a result of inflationary pressures will lead to rising yields and cap rates, which in turn would mean declining market values, provided that rental levels do not increase by a magnitude that cancels out this effect. In summary, if yields go up because interest rates rise, and work from home continues to lead a slowing demand for office space, some property markets and submarkets could be in for the perfect storm, which in turn would lead to a higher default and loss risk for the relevant CRE loans.

However, most of the office loans backing CMBS transactions that we rate either are in markets that we do not expect to be severely affected by deteriorating rents (such as Frankfurt or the primary and secondary markets in the Netherlands) or are generally backed by higher quality Grade A office stock (such as the central London office properties that back CMBS loans), which we believe is better positioned to remain attractive.

Retail properties are a different story. The struggle is not over for this subsector in general and for the U.K. shopping centers in particular, especially those in secondary locations with smaller catchment areas. While value declines appear to have slowed and operating cash flows have stabilized among the shopping centers for which we receive regular reports, income still remains significantly depressed compared with pre-pandemic levels, leaving landlords little room to invest in their assets. More importantly, the rapidly accelerating trend toward online shopping, which had started the slow decline in retail asset values years before the pandemic, is far from over. In fact, it has become even faster as more consumers became used to ordering products from their living rooms while shopping destinations were closed.

Related Criteria

• European CMBS Methodology And Assumptions, Nov. 7, 2012
• CMBS Global Property Evaluation Methodology, Sept. 5, 2012

Related Research

• European CMBS Monitor Q1 2022, April 20, 2022
• Asset Price Risks: Inflated Property Values Mean Higher Loss Assumptions In European RMBS And Covered Bonds, March 21, 2022
• S&P Global Ratings Definitions, Nov. 10, 2021