May 8, 2018
- Unlike the previous cycle, U.S. commercial real estate is not over-leveraged.
- This suggests that real estate may offer a defensive strategy in coming years.
- CBRE’s house view is expressed despite the recent International Monetary Fund (IMF) warning on debt levels in the global economy.
The build-up in U.S. commercial real estate debt levels has been much more measured than in previous cycles, in particular prior to the Great Financial Crisis (GFC). Figure 1 shows that real estate debt as a percentage of U.S. GDP reached a peak of 23.1% in 2009. After the GFC, commercial real estate de-levered, with the ratio of commercial real estate debt to GDP falling to 19.1% in 2013. While overall asset values in the U.S. are now substantially above their previous pre-recession peak, debt accumulation has lagged. As of 2017, the ratio of commercial real estate debt to GDP (20.9%) remains more than 2.2 percentage points below its previous peak. This contrasts with the expansion of private and sovereign debt levels globally, which is of concern to the IMF. While current commercial real estate debt levels are above the long-run average of 17.9% since 1990, we think they are sustainable in a continued low-inflation and low-interest-rate environment.
Lenders and owners have been more cautious in deploying property-level leverage during this cycle. Loan underwriting is more conservative. Institutional owners, for example, carry lower property-level leverage now than they did prior to the GFC. According to NCREIF, debt-to-market value is currently 41%, compared to an average of 48% in 2007. CBRE’s measures of commercial property loan-to-value ratios (LTVs) on permanent, fixed-rate financing also show lower levels of leverage compared to 2007 (59.8% vs. 75.3%). Furthermore, the quality of loan underwriting is better, adjusting for loan amortization and stressed cap rates. In 2007, we estimated that the percentage of loan originations carrying a stressed refinance LTV of 100% or greater was 26.6%; for 2017, the comparable figure is 14.1%.
According to the IMF, global debt has reached historic highs—the equivalent of 225% of global GDP—and is now 12% higher than its previous peak in 2009. Both public and private debt levels are surging across developed and emerging economies. The IMF’s concerns are related to global macroeconomic risks that may be elevated by rising interest rates acting on elevated levels of debt. We share this view, but we also believe that U.S. commercial real estate debt should be distinguished from rising levels of corporate and sovereign debt.
While commercial real estate will have to face the same macroeconomic volatility as all other asset classes, its lower leverage may offer investors a more defensive strategy in the event of a sharp rise in rates. Under a scenario of de-leveraging in other more highly levered markets, such as certain corporates or emerging markets, commercial real estate may outperform. Furthermore, if the rise in rates is accompanied by higher-than-anticipated inflation, real estate may serve as a more effective hedge than other sectors, such as corporate bonds and sovereign debt.