The earliest-known real estate crisis is documented in the Old Testament, a high-rise in the city of Babel. We don’t know what the Babel Tower looked like, of course. But according to pictorial representations of Pieter Bruegel the Elder, whose two 16th-century paintings of the abandoned undertaking can be admired in the Kunsthistorisches Museum, Vienna, the abandoned construction site was a total mess.
The project was an exercise of hubris from the very beginning: vast, sky-high, useless, and unsuited to its surrounding. It was a vanity project without a sound business plan, not taking account of possibly ruinous risks.
While we try hard to challenge Him, we don’t suffer the wrath of God in Malta yet. But we can see a modern-day Babel in the German city of Hamburg: the Elbtower. Planned to be the highest building in Hamburg and – with 245 metres – the third-highest in Germany, the cranes stopped at 100 metres now, on the 25th floor. The continuation could not be financed anymore. The workers went home, bemoaning their plight in many different languages.
Real estate, particularly commercial real estate (CRE), is in trouble all over the world. The reasons are multi-fold, as I will soon explain. But the main reason is inflation, and the rapidly rising cost of borrowing. After the supply disruptions brought upon us by COVID lockdowns and the spike in energy costs after the invasion of Ukraine, the price of everything – from building materials to workers’ salaries – went through the roof. Calculated profits evaporated.
With central banks fighting the scary reappearance of rampant inflation by aggressively raising interest rates, new mortgage loans became hard to afford. The burden of CRE credit, no matter how well-secured, became unbearable for borrowers and lenders alike. Property valuations started to melt as the servicing of loans started to exceed achievable rents.
A real estate investment can be compared to a fixed-interest bond. When interest rates rise, the value of the bond must fall. The bond, issued at the time with interest rates fixed at the then prevalent, lower levels, is not compatible anymore to the income streams promised by newer issues. Its price will fall until its yield to maturity will match newer issues. Real estate returns, their paid rents, are following the same pattern. Fixed rental income will not compare well to returns achievable in the bond markets. Real estate values must fall. While true in principle, bonds and real estate values can deviate from the rule by market circumstances.
Take inflation-protected bonds or floating rate notes. Their income streams will adapt to new interest rate levels. Bond prices will therefore suffer less. As long as landlords can raise rental demands in congruence with inflation (and their rising interest rate obligations), their real estate investment should suffer less. Until rent increases cannot be fully imposed anymore, simply because renters cannot afford ever-higher rents and will refuse, or move out.
Influential for the preservation of real estate value is also the supply situation. If there are not enough houses around, even for drastically diminished demand, prices will stay stable. Malta is a special case: valuations of properties don’t change, even when units stay unsold for ever. Banks, real estate developers and rental landlords find a common interest in this.
A good, example for value-destroying over-supply are Chinese apartment buildings. For many years, Chinese residential real estate developers were seen by the CCP as engines of growth.
Cheap loans, cheap land and the political will to swamp the country with cranes for the sake of economic expansion produced nothing but vast suburbs of empty apartment blocks all over the country. Nobody wanted to live in them, but they were gobbled up by retail savers in the belief that housing will always boom. Now valuations came crushing down. The construction behemoths pampered for a long time are going bust one after the other. Retail investors, often invested in not-yet-built and now never-to-be-built apartments, lost big time.
Warning signs are flashing red all over Europe and the rest of the world– Andreas Weitzer
The warning signs are flashing red all over Europe and the rest of the world. Commercial real estate is in the eye of the storm. CRE is not a homogeneous investment class, though. It comprises apartment buildings, hospitals, warehouses, hotels, even forests. Not all of them an equally bad investment. But then there are the shopping centres and offices, which have now become increasingly risky. Offices – and the Elbtower in Hamburg was mainly an office development – face trouble far beyond higher interest rates and cost inflation.
Since the lockdowns and the discovery of the comfort and technological ease of working from home, occupancy rates of office complexes have painfully declined. In major cities like London, up to 40 per cent of the available office space remains empty. We Work, until recently one of the biggest landlords outside China, went bust. Its business concept, to lease long term and to let out short term on a vast scale, was a rental gamble turned awry.
This trend out of the office will reverse gradually. But it will not go back to where it was before. The second threat darkening the office space future is environmental regulation. The majority of existing, older office buildings is unfit for modern CO2 emission standards. Badly insulated, badly sunlight-protected, it is a polluter endangered by carbon concerns.
This does not even account for the changes AI will bring about. Office jobs like working on Excel spreadsheets, accounting, the drafting of letters and reports, regular legal advice and standard correspondence, will be soon replaced by the likes of ChatGPT. This will reduce the required staff size and hence the need to put up tables in back offices and headquarters. Even if workers were willing to work in offices full-time, it will be fewer of them. Investors have a gut feeling about it. Real Estate Investment Trusts (REITs), established for decades and soon to be launched on the Malta Stock Exchange, which enable retail investors to put savings in the development and management of buildings, are down 30 per cent.
It is not only REITs and bonds of developers which are punished now. Many banks have loaned to developers on the basis of expected sales prices and rental income which look now as inadequate as the valuations of the properties they have mortgaged. Their loans look now decidedly overvalued.
This will force banks to book loss provisions and to tighten lending standards. They will refuse to throw good money after bad. Developers in need of fresh credit and capital will sit high and dry, and the banks will end up with secured property nobody wants. It is one thing to mortgage the Elbtower. It is an entirely different matter when you end up owning an unfinished Tower of Babel nobody wants to complete.
The Austrian entrepreneur Rene Benko, high-flying society darling with a property portfolio encompassing iconic landmark buildings like the Chrysler Tower, Selfridges or the KaDeWe in Berlin, and master builder of the Elbtower nightmare, sees his empire collapsing, like Czech billionaire developer Radovan Vitek and others. The first sign of waning fortunes is becoming manager of the year in business journals. Retail investors beware!
Sadly, the implosion of real estate czars is also a danger for banks as well as the wider economy. Banks are better capitalised and better regulated since the Great Financial Crisis of 2009, and will not go under. But by being damaged, they will have diminished earning prospects and cause a drag on overall growth by tightening their lending conditions.
Retail investors can easily stay clear from local banks and developers. To escape wider economic repercussions is difficult though. Elevated interest rates will cause more damage. Banks and insurance companies have been caught unawares by the hidden and not-so-hidden pitfalls of elevated interest rates. We retail investors should act more wisely.