Commercial Real Estate at a Crossroads

IMF Blog, March 29, 2021

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The pandemic reduced demand for commercial real estate, especially in retail, hotel, and office segments, due to containment measures that shuttered businesses and offices.
Recent IMF analysis finds pandemic-driven and structural trends—decline in demand for traditional brick-and-mortar retail in favor of e-commerce, and lower office demand as work-from-home policies gain traction—could disrupt commercial real estate markets and potentially threaten financial stability.

Commercial real estate can affect broader financial stability because:
- The sector is large.
- Its price movements tend to reflect the broader macro-financial picture.
- It relies heavily on debt funding.
In many economies, commercial real estate loans constitute a significant part of banks’ lending portfolios.
Nonbank financial intermediaries (e.g., insurance firms, pension funds, or investment funds) also play an important role in commercial real estate funding in some jurisdictions, although banks remain the largest providers of debt funding globally.
An adverse shock to the sector can:
- Put downward pressure on commercial real estate prices.
- Adversely affect the credit quality of borrowers.
- Weigh on the balance sheets of lenders.
Price misalignments—when prices deviate from those implied by economic fundamentals or “fair values”—magnify downside risks to future GDP growth:
- A 50-basis-point drop in the capitalization rate from its historical trend could raise downside risks to GDP growth by 1.4 percentage points in the short term (cumulatively over 4 quarters) and 2.5 percentage points in the medium term (cumulatively over 12 quarters).

The pandemic increased price misalignments in commercial real estate.
Unlike previous episodes, current misalignment stems largely from a sharp drop in operating revenues and overall demand for commercial real estate, not from excessive leverage buildup.
As the economy gains momentum, misalignment is likely to diminish, but potential structural changes driven by evolving consumer and corporate preferences could pose lasting challenges:
- Scenario: A permanent increase in commercial property vacancy rates of 5 percentage points could lead to a drop in fair values by 15 percent after five years.
There is substantial uncertainty about the outlook for commercial real estate, making definitive assessments of price misalignments extremely difficult.

Low rates and easy money can help nonfinancial firms access credit and support recovery in commercial real estate, but could also encourage excessive risk-taking and contribute to pricing misalignments.
Policymakers could consider macroprudential measures to counter financial stability risks, including:
- Limits on loan-to-value ratios.
- Limits on debt service coverage ratios.
- Broadening macroprudential policy to cover nonbank financial institutions involved in commercial real estate funding.
- Using stress testing exercises to assess whether banks have set aside adequate capital for commercial real estate exposures.

Source: Commercial Real Estate at a Crossroads — Andrea Deghi, Fabio Natalucci, March 29, 2021.