Reserve Bank warns that commercial property could face distress in downturn

The central bank has warned that while the sector is well-placed, there could be forced sales in an economic downturn if borrowers can’t refinance.

The Reserve Bank has warned that risks around the fragile commercial property sector would increase if economic conditions were to deteriorate substantially.

Banks were burnt by their exposures to developers in the sector crashes after the 1980s boom and in the wake of the global financial crisis but owners of top office towers and shopping centres have insisted they can weather the storm of higher interest rates and the weaker economy.

The central bank’s latest financial stability review said that landlords appeared to be coping with soft leasing conditions and higher rates but warned that if rental income were to fall sharply in an economic downturn, some landlords are likely to become financially distressed.

It noted that listed Australian Real Estate Investment Trusts – which directly own around 10 per cent of office space and 60 per cent of retail properties, and are exposed to some developments – were well placed to handle lower rents and valuations because they had strong balance sheets.

“In general, A-REITs are not highly leveraged, although their leverage will increase if declining valuations lead to markdowns of the book value of their properties,” the bank said.

But values are sliding and the situation is unclear for smaller mum and dad landlords. The Reserve Bank said its liaison with banks suggested the vast majority holding small bank loans were meeting rising debt payments.

“The risk of forced property sales (or in severe instances, defaults) could emerge if some leveraged investors cannot refinance expiring loans,” the bank review said.

“This could occur if higher interest rates cause some existing loans to fall below minimum interest coverage or maximum loan to valuation ratio requirements and the investor cannot contribute more equity to the property to offset this.”

The Reserve Bank said that borrowers who were unable to refinance with banks could still refinance with non-banks, albeit at higher interest rates. It noted that larger commercial property investors who borrow in global capital markets could face refinancing difficulty if liquidity in these markets was significantly reduced.

Direct exposures to commercial property are only 6 per cent of assets and non-performing exposures are negligible, with banks also protected by conservative credit policies after previous crashes.

But even the central bank admitted that little information was available on exposures to commercial property outside the banking sector. Its industry contacts showed that non-bank lenders had some exposure to commercial real estate, and on slightly different terms to banks.

“However, broader systemic risks posed by the non-bank sector are limited by its relatively small size in Australia,” the review said.

Originally published as Reserve Bank warns that commercial property could face distress in downturn