(Editor's Note: In this series of articles, we answer the pressing Questions That Matter on the uncertainties that will shape 2024—collected through our interactions with investors and other market participants. The series is aligned with the key themes we're watching in the coming year and is part of our Global Credit Outlook 2024.)

Higher-for-longer interest rates remain the key risk for real estate assets globally. The distress will likely be drawn out on the commercial side, and especially in the U.S. where office vacancies are relatively higher. In China, as the property downturn continues, we expect property sales will track an extended L-shaped recovery in 2024.

How This Will Shape 2024

As the real estate sector confronts credit headwinds globally, persistent and prevailing risks differ across type of real estate, region, country.   This is true even for office buildings that are right next to each other based on asset quality, occupancy, maturity profile, and more. And while high interest rates remain the key risk for real estate assets globally, remote working is hurting U.S. office landlords more than in Europe and China—as demonstrated by average vacancy rates (see chart 1). Homebuilders are also facing diverging paths, largely based on geography; the U.S. housing market remains resilient due to limited supply of existing housing while Chinese property developers are facing a prolonged slump in demand. We expect real estate issuers to face a challenging operating environment in 2024 given our expectations for interest rates to stay higher for longer while revenue is pressured from weaker economic growth. We expect rates to stay elevated in the next year, with gradual cuts beginning in the second half of 2024.

Charts 1 and 2

Stress on the office segment remains high.   Across commercial real estate, higher interest rates have reduced debt-service coverage and raised refinancing risk. Declining demand for office space—particularly in major cities across the U.S., U.K., continental Europe, and Australia—is weighing on asset valuations (see chart 2). Demand increasingly concentrates on the most centrally located and energy efficient assets. Offices in particular are also generating lower levels of cash flow given increasing financing costs and credit headwinds. Rising operating expenses as well as leasing incentives (e.g., rent concessions) have made it that much harder to meet interest obligations, resulting in increased delinquency rates. Still, the picture is far less negative for cash flows/revenues from hotels, industrial, and multifamily properties, which have held up well to date. The stress in office will be drawn out for years, as office leases typically carry longer terms – ten years or more.

Higher mortgage payments are hurting affordability.   For residential real estate, the rapid rise of mortgage rates is also dampening housing demand globally as buyers are adjusting to the highest rates in almost two decades. We expect the U.S. and European housing markets to face pressure, given worsening housing affordability. As steep increases in mortgage payments hurt home purchasability, rental housing remains a cheaper option in many markets. We expect rental housing demand in 2024 to remain healthy, albeit at slower pace. In Europe, residential rents will remain supported by lagging indexation, falling supply, and higher demand from immigration.

Property sales in China will track an L-shaped recovery in 2024,   after a decline of more than one-third since the peak in 2021. As the property downturn enters into its third year, the government's continuous policy relaxations (including lowering mortgage rates) aimed at stabilizing the sector will benefit the upper-tier markets, particularly the first-tier cities. Lower-tier cities are contending with excess supply and depleted confidence. All developers will have to manage slowing sales; in our view, their leverage will remain high for the next two years. In Hong Kong, we expect residential property prices to fall in 2024, as leading developers will likely lower prices to entice demand, as well as sacrifice margins to meet their contracted sales targets and to gain market share.

What We Think And Why

Refinancing risk is growing.   Higher-for-longer interest rates will continue to pressure asset values and erode credit metrics in 2024, increasing refinancing risk across all property types. Refinancing options remain more limited, given a pullback from bank lending while debt issuance remain subdued due to steeper cost of borrowing. In the meantime, real estate transaction volume remains low and will not likely recover until rates start to decline (or at least stabilize), perhaps toward the end of 2024.

Amidst challenging financing conditions, we expect an increase in downgrades   and many loans to be restructured or default if maturities are unable to be extended. We maintain a negative rating bias for the REIT sector globally—with about 20% of U.S. ratings on negative outlook, compared to 26% in EMEA and Asia-Pacific's 21% negative rating bias. In the U.S., the office REITs space saw four fallen angels in 2023, and almost 40% of office REITs were speculative grade as of November 2023. Growing refinancing risk has led to a growing number of 'CCC' ratings in the U.S.

Chart 3

The effects on ratings are already evident in the U.S. CMBS market (with some 254 class ratings lowered in the 12 months ended Oct. 31, 2023). Negative rating bias has also increased significantly for rated REITs globally, and we have downgraded a growing number of issuers with significant exposure to office assets. For banks, there have been increases in criticized assets/loans (that is, showing a higher probability of default or deteriorating collateral values). Across CRE loans and reserves, the impact seems muted for the larger entities that we rate. For newer class-A offices with strong tenant rosters, or other types of CRE where the distress largely stems from higher rates, lenders may extend loan maturities in the hopes that a decline in interest rates and stabilization of property valuations will soon materialize. For example, we're watching multifamily closely in the U.S. as some properties were underwritten at what might be peak rents, thus having less margin for any corrections amid significantly higher rates.

Limited housing supply mitigates soft demand in housing.   Despite sharp increases in home mortgage payments, we expect demand for housing to remain resilient due to limited supply of homes and relatively benign job markets in the U.S. U.S. homebuilders have gained share as existing homeowners are reluctant to sell their homes at low mortgage rates, while European homebuilders continue to face strong margin pressures due to significantly lower demand for newly built residentials and elevated costs of constructions. Conditions for Chinese developers remain challenging. We believe the spillover impact from China's property market into other property markets will likely be limited given the risks to Chinese banks are manageable. These institutions have sufficient capital buffer to absorb the potential losses from property-sector write-downs, while government policies are helping stabilize residential sales, particularly in higher-tier markets.

What Could Go Wrong

Higher for even longer could increase downside risk.   The credit outlook for both global commercial and residential real estate depends on the path of benchmark interest rates, likely more so for commercial. While our macroeconomic base case does not call for a recession in 2024, weaker growth with higher unemployment and consumer spending could further pressure real estate demand, particularly in a prolonged high-rate environment.

Loan distress could increase.   Amid higher rates, declining asset values, and lower cash flows for certain property types, elevated CRE-related loan losses may rise for debtholders including banks, NBFIs, insurers, REITs, and CMBS. Reduced construction/new projects may also contribute to slower macroeconomic growth, amid relatively lower demand for space.

A weaker macro landscape can slow demand further.   If interest rates remain elevated for much longer, residential investments could deteriorate significantly. If interest rates remain high or move even higher, the already stressed market for refinancing would certainly worsen—and the prospect of "higher-for-longer" loan rates could thwart any plans borrowers may have to simply wait conditions out by extending their loans. While we expect benchmark rates to stay elevated in the next year, our U.S. base case calls for gradual (policy) rate cuts beginning in the second half of 2024, lowering mortgage rates from peak levels and supporting a recovery in housing demand in 2024 and beyond. Persistently high mortgage rates could erode demand such that housing could see more material pricing decline.