The Reserve Bank (RBNZ) has released a Financial Stability Report on commercial property showing that weak tenant demand in parts of the sector has led to higher vacancy rates and soft rental growth over the past couple of years.

“At the same time, high interest rates have strained owners’ cashflows and reduced property values,” says Kerry Watt, RBNZ’s financial stability assessment & strategy director.

Commercial property – office, retail, industrial – is vital for economic activity. They provide the physical infrastructure for general economic activity and the performance of commercial property markets will reflect a country’s economic conditions.

Historically, the performance of the sector has been sensitive to economic cycles. The sector can amplify financial sector impacts in economic downturns, he says.

“However, the financial system is well placed to manage the risks. Enhanced regulatory requirements and improvements in lending standards mean we have a system that is more resilient than in the past,” he says.

Property values have fallen about 10 per cent from their 2021 peak, primarily reflecting higher interest rates.

Despite the effect of higher interest rates, rental growth has underpinned property values across some subsectors, Watt says. While rents fell overall during the pandemic, they increased about seven per cent last year. He says rents have been supported by relatively muted supply growth in the context of robust population growth over the past decade.

“Currently, regulatory uncertainty, slowing economic activity, high interest rates and increased ownership costs are making new development projects less viable. The pipeline of new development is therefore likely to slow over coming years due to a lack of new projects.”

Higher local council rates and insurance premiums are affecting tenants and property owners. The ending of depreciation tax deductions for commercial and industrial buildings came into effect in April, and although its overall market impact is small, it could add to existing cashflow difficulties for owners given the challenging market.

Sectoral differences

The situation in individual sectors of the commercial property market varies considerably.

Commercial property can be broadly divided into industrial (factories and warehouses) and office and retail (restaurants and shops). Each of these can be further subdivided into prime and secondary (CBD and suburban for retail).

The industrial sector accounts for the largest share of floor space and total property value. Demand has remained robust, while the supply of new industrial space is severely constrained by a lack of suitable land.

In the office sector, market sentiment is more subdued. Recent structural changes, with the increasing importance of working from home, are also affecting the sector in New Zealand.

A common phenomenon is the “flight to quality”, with companies renting less office space but of a higher quality. In Auckland, this trend is reflected in substantially higher vacancy rates for lower quality office buildings since the pandemic and an increasing share of prime office space.

Conversion of existing secondary office space into more lucrative residential assets is possible, but difficult due to high costs.

The ongoing transformation of the office sector is putting pressure on owners of lower quality assets. They are struggling to sell or lease their properties and find it difficult to access funding on terms that would make it viable to redevelop, refurbish or renovate.

Recently, property owners have also noticed a shift in sentiment in the prime office sector. With rising vacancy rates and reduced buyer activity, a slowing economic outlook is also weighing on parts of the sector.

The retail sector has been relatively resilient to the emergence of online competition. NZ retailers have been heavily involved in e-commerce since the early 2000s, and this has grown in importance during the pandemic.

Other factors are more challenging for the retail sector. High inflation and interest rates affect retailers in two ways. Firstly, through the affordability of their own business financing and, secondly, through constrained disposable incomes and subdued consumer discretionary spending.

The poor economic outlook has reduced consumer confidence, causing them to hold back on retail spending, especially non-essential purchases.

This puts further pressure on the retail sector, especially for smaller and discretionary retailers outside core shopping areas. In some cases, tenants have been able to renegotiate their rent to reflect the adverse conditions.

While tourism has recovered, its impact is uneven across locations and tends to be seasonal.

Regional differences

Auckland is experiencing the most pronounced shift in demand from secondary to prime commercial properties, which has been exacerbated by a geographic shift in demand towards the waterfront and a drop in private education facilities due to the falling numbers of international students.

Wellington is underpinned by the large public sector demand, which features long-term office leases. A drop in government spending could put downward pressure on office demand. Another challenge is ongoing revisions to seismic regulations. With uncertainty about the outcome of these changes, some developers are holding back on investments in seismic upgrades until the official regulatory framework is updated. Geographic constraints have been limiting supply for the industrial market.

The market in Christchurch has been shaped by the 2010/11 earthquakes. Vacancy rates remain low across all sectors compared with the other two regions, while prices have been relatively stable. This reflects the broadly matched demand and supply through the city’s rebuild.

The financial connection

Commercial property is connected to financial systems through various channels.

A key channel is the lending activities of banks. In the first quarter of this year, banks had $44 billion in lending to commercial property, about eight per cent of their total loans. Non-bank lenders play a smaller role in financing commercial property and tend to focus on development lending.

Commercial property lending carries risks.

A deterioration in commercial property markets can affect lenders in several ways:

• For lending to finance existing buildings, reduced tenant demand, excess supply, rising vacancy rates, and high interest rates will lower the value of buildings used as collateral for loans and the rental cashflows available for debt servicing.

• The financing of new developments is inherently risky, as the viability of a project is uncertain and can be affected by construction delays, cost escalation, and potentially a lack of pre-committed tenancies prior to completion. Lenders are exposed to risk as the cashflows to service or repay the debt only become available on a project’s completion, while the value of the asset being developed may fluctuate depending on market conditions.

Where the above factors put property owners under acute stress they may default on their loans and not be able to fully cover their debts by selling properties, leading to losses for the lender.

Amplifying economic downturns

The commercial property market is procyclical in nature.

This procyclical demand from investors is because commercial property is a relatively risky investment class. In periods of financial and economic upswings, borrowers’ and lenders’ risk appetite increases, and the demand and valuation of commercial property tends to increase.

This process reverses during downturns, which puts stress on the financial system. A slowdown in commercial property can also spill over into other sectors of the economy through its impact on the construction industry and employment.

A downturn in the market can be particularly damaging to the financial system if vulnerabilities are not managed during periods of strong economic activity.

The high-risk profile of the commercial property market is evident in historical episodes of financial system stress, including in the US, the Nordic countries, NZ and Australia in the late 1980s, and the US and Ireland in the late 2000s.

Default and loss rates for loans to commercial property are among the highest across sectors in economic downturns and in our stress testing of banks, Watt says.

To manage the risk of their commercial property exposure, banks are required to hold more capital against this lending than against lending to sectors such as housing. This is done through having higher risk weights on commercial property lending than on lower risk lending, such as mortgages.

The back story

Historically, financial crises have often been exacerbated by downturns in the commercial property sector. During the GFC slowing economic activity triggered a sharp fall in commercial property prices. Although the US housing market was at the centre of the crisis, commercial property prices fell more sharply than house prices in most economies.

Commercial property played a central role during NZ’s period of financial stress in the late 1980s.

Following financial liberalisation and deregulation, commercial property prices surged in the mid-1980s, leading to increased construction and development activity.

After stock prices fell sharply in 1987, indebted companies experienced increased financial stress, which subsequently led to rising vacancy rates.

Combined with a large amount of new supply entering the market, commercial property prices fell substantially. Subsequently, many commercial property loans defaulted, resulting in substantial losses for banks.

NZ’s system of prudential regulation of banks was only in the early stages of development during this period, allowing banks to lower credit standards and ultimately leading to the government bailout of the Bank of New Zealand.

Problems in offshore markets can also affect NZ’s financial stability. Foreign capital plays a role in the commercial property sector. The scale of these investments is hard to measure, but discussions with market contacts suggest it’s mainly concentrated in Auckland and generally limited to larger investments. A lack of liquidity in the rest of the market and increasing economic uncertainty have made foreign institutions reluctant to invest more widely.

Weak conditions in global property markets could add to domestic slowdown if foreign investors prefer to invest in safer assets or in their own jurisdictions. However, to date international capital continues to view NZ as a relatively stable market that still offers higher returns.