Views From the Floor - Cracks in European Commercial Real Estate?

The unintuitive relationship between Beta and Momentum; and as the banking crisis comes off a boil, in which sectors might the dominoes fall next?

 

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Cracks in the European Commercial Real Estate Sector?

Last week , we spoke about how we thought the US commercial real estate (‘CRE’) sector would be the next domino to fall as the banking crisis comes off a boil. The main driving factor behind this is that small- and medium-sized banks – that make up the bulk of US lenders – account for 70% of all commercial real estate loans. A renewed focus on liquidity in the banking sector could result in a tightening in lending conditions.

Is the European CRE sector also experiencing some of the same cracks in the woodwork?

At first glance, CRE makes up only 9% of European banks’ loan book,¹ a much lower figure than the US. However, the European average hides a wide range. Where Spanish banks only have a 5% exposure to the sector, for Sweden, 25% of total bank loans are made to fund CRE.²

The other factor to consider – and one where Sweden also stands in contrast – is the lower overall leverage in the system. In the years preceding the Global Financial Crisis, lenders routinely offered loans of 80-100% of a building’s value, while loan-to-value (‘LTV’) ratios rarely go above 60% these days. Sweden has average LTV of almost 50%, versus the UK on 30%.³

In addition, Swedish property companies have shorter duration debt maturities with about a third of their debt due within the next two years.⁴ This could prove challenging if Nordic banks decide to decrease their exposure to CRE.

Overall, Sweden’s commercial real estate sector is a fairly isolated case of potential stress due to the concentration of lending among the Nordic banks. Whether this will accelerate into a sector-wide crisis across the European continent seems unlikely at this point, in our view.

The Signal Forecasting a US Recession

Are we heading towards a US recession? According to one signal, the answer is yes.

Demand for temporary workers – first to be added when demand is increasing and easiest to cut when growth decreases – is down markedly from a year ago. As shown in Figure 1, temporary employment acts as a leading indicator for US jobs and recessions (illustrated by the shaded regions in the figure).

In combination with wages rising at the slowest pace since June 2021, this suggests that the US labour market is finally softening, giving the Federal Reserve some room to pause the interest rate hiking cycle.

Figure 1. Declines in US Temporary Payrolls Historically Precedes a Recession

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Source: Bloomberg, Man Group; as of 31 March 2023.
Shaded areas are US recessions.

With contribution from: Brentley Campbell (Man GLG, Portfolio Manager) and Henry Neville (Man Solutions, Portfolio Manager).

1. Source: Goldman Sachs.
2. Source: DBRS Morningstar.
3. Source: Kempen.
4. Source: Kempen.