European Commercial Real Estate Values May Fall Up To 40%: Citi

Europe’s real estate companies, which have already been performing poorly this year, are likely to face further challenges as increasing interest rates lead to higher financing costs. Moreover, concerns among investors regarding the future prospects of commercial property developers are exacerbating the situation.

In Sweden, property stocks – considered a precursor for the problems afflicting European real estate – have been declining this week. This is because SBB, one of the country’s largest commercial landlords, has suspended dividends and cancelled a rights issue after its debt ratings were downgraded. This development is unfavourable for the Stoxx 600 Real Estate Index, which has lost approximately €140 billion ($154 billion) in market value since its peak in August 2021, representing a decline of 45%.

According to Citi analyst Aaron Guy, the value of commercial real estate assets in Western Europe may decline by as much as 40%, which could result in covenant breaches and necessitate the injection of up to €178 billion in new equity or “other mitigating actions.” This amount is larger than the entire market capitalization of the real estate sector index, which stands at €144 billion.

Citi’s Guy suggests that covenant risks and the need for real estate refinancing to achieve lower loan-to-value ratios require a “substantial re-equitization” in the sector. While this could result in a downside in the short term, it may present a medium-term opportunity, according to him. Furthermore, the sector, which is sensitive to interest rates, is under strain following the announcement by the European Central Bank that its tightening policy is not yet complete. Some officials are challenging the market’s assumption that the cycle will end in July. As sentiment deteriorates, Barclays and JPMorgan strategists are among those bearish on the sector.

According to Barclays strategists, who view the sector as a bond proxy and are underweight, higher interest rates could result in lower valuations and potential rights issues. In addition, the trend towards remote working and retail digitalization presents a challenge for stocks. JPMorgan strategists also have an underweight position due to weak fundamentals, but suggest that stalled bond yields may offer some relief. Meanwhile, Bank of America’s analysts are more positive, asserting that the expectation of lower bond yields during a recession is a reason to be overweight on real estate this year.

Swedish real estate faces significant risks as it has experienced high growth driven by historically low-interest rates in the last decade. Over $40 billion in bonds will mature in the next five years, with a quarter of them due in 2023, which is concerning as much of the debt is short-term and has a floating rate, exposing it to interest rate risks. Additionally, many of these companies have complex shareholding structures that overlap with several listed firms, creating the potential for a chain reaction triggered by a single margin call.

While the likelihood of SBB’s current difficulties spreading to other major Swedish landlords is not high, Danske Bank equity strategist, Molly Guggenheimer, believes that the suspension of dividends and the cancellation of the rights issue will be “yet another negative overhang for the sector.”

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