.png)
"The second quarter signifies the onset of repercussions for real estate companies due to rising financing expenses and reduced demand for office space. We anticipate that this trend will persist throughout 2023."
In May, Swedish inflation measured by the Consumer Price Index (CPI) stood at 9.7%, showing a slight decrease from April’s figure of 10.5%. Meanwhile, the CPIF, which excludes energy, was recorded at 6.7% compared to 7.6% in April. The persistent factors contributing to high inflation include rising interest costs for household mortgages and increasing prices for various goods and services. However, prices for food and energy products continued to decline.
During the second quarter, the Swedish central bank (Riksbanken) continued to tighten its monetary policy in response to mounting pressure both within the EU and from the USA.
The fbindex that monitors listed real estate companies on the Stockholm exchange, experienced a significant decline primarily driven by widespread investor concerns, stemming from factors such as deteriorated credit rating, reduced cash flows, and decreased asset values held by real estate companies.
The policy
A total 75 basis point increase was set by the Swedish central bank during Q2 (as of the end of June). This gives Sweden the second highest policy rate in the Nordic region, right after the ECB, which Finland follows as a member of the Eurosystem.
The Central bank is taking steps to curb inflation by implementing active monetary policies. Additionally, liquidity in real estate corporate capital markets has declined, leading to increased funding costs. Although Nordic banks continue to demonstrate interest in lending, they are primarily prioritizing established relationships and are offering lower refinancing loan-to-values (LTVs). This due to increased scrutiny of interest-coverage ratios (ICRs), resulting from the continuing rise of interest rates.
After the recent rapid policy rate hikes, the Swedish monetary policy has clearly tightened, impacting the overall economy. It is anticipated that the central bank will proceed with smaller adjustments to the policy rate in the autumn. We expect another potential increase of 25 basis points to ensure the crucial inflation target is met by 2024.
When such a policy is implemented, it will further raise the funding costs for real estate companies seeking to refinance their current bond portfolios. This, in turn, will place additional pressure on their interest coverage ratios, creating stress factors among investors and shifting the focus towards bank financing options.
Debt Profiles
In mid-May, two prominent credit agencies, S&P and Fitch, downgraded the credit rating of the Swedish real estate company SBB (One of the largest listed real estate companies in the Nordics, holding a portfolio value of SEK134.4 billion (approx. €12 billion) in March 31, 2023) to what is commonly referred to as "junk" status. They also revised their outlook to negative, citing inadequate deleveraging efforts.
As a result, the stock price experienced a significant decline of nearly 40% over the following two consecutive trading days, highlighting heightened concerns regarding refinancing and liquidity risks. Investor confidence further diminished during this period. SBB also observed an expanding credit default spread on its traded bonds, surpassing the sector average. Additionally, the company is encountering difficulties and a deteriorating ability to access capital markets, posing significant challenges.
Swedish real estate companies are facing challenges due to rising inflation and increased funding costs, rendering their debt-driven growth strategies unprofitable and unfeasible as refinancing options dwindle. Several companies have experienced downgrades in their credit ratings and received negative outlooks for their debts. It is anticipated that further negative rating actions and heightened scrutiny of the Swedish real estate market will occur during the rest of 2023.
The Swedish krona has experienced a significant decline in value, partially attributed to the monetary policy pursued by the Riksbanken in the past. The new appointed governor has acknowledged the weakness of the currency as a concern. Currently, the Riksbanken is assessing the feasibility of reducing its central bank bond portfolio to curb the anticipated decrease in bond yields. Proper divestment and deleveraging strategies are already in place for many companies in the sector, which might open up opportunities for foreign investors as an avenue for growth, albeit with some associated currency risks.
Earning strategies
“While waiting for the cost of capital to be stabilized, earning strategies have been the focus for almost the entire sector.”
The majority of premium assets in Stockholm are predominantly owned by institutional/pension funds owned real estate companies. These entities have traditionally operated with higher loan-to-value (LTV) ratios and net debt/EBITDA ratios. Despite increased financing uncertainties, the lower vacancy rate in Stockholm's central business district (CBD) and CPI-linked leasing contracts will help mitigate some of these challenges. However, we have noticed that many participants in the market are exploring alternative options, such as flexible rental contract lengths, reduced rent levels, and co-management of properties with major co-working operators.
Tech companies have experienced setbacks in their leasing contracts, primarily due to a weaker economic outlook. These companies have played a significant role in driving new leasing contracts, particularly for premium assets, over the past decade. This headwind has created opportunities in the secondary market, where there is a strong demand for sustainable space in prime locations, with a premium placed on flexible leases. The demand for modern and high-quality premises remains robust. We anticipate that leasing activities will remain stable during the upcoming third and fourth quarters.
Maintaining flexibility in leasing terms and conditions, as well as continuing to invest in the existing older assets within the portfolio, will be crucial for the entire sector, particularly during these challenging times.
Outlook
Despite the strong recovery in the office rental market, the second half of 2023 is expected to present challenges for the entire sector, primarily due to aggravated economic conditions. The divide between premium (A) and lower-grade (B/C) properties will continue to widen throughout the year.
We anticipate that the cost of funding will reach its peak during the next interest rate announcement at the end of the year. As a result, credit profiles for certain companies in the sector will continue to be adjusted. There is also a likelihood of a continued mergers and acquisitions and/or market reshuffling during the third quarter.
The high interest rate environment has prompted certain investors to structure acquisitions with minimal bank financing (LTV) or with low percentages (below 20%). Notable examples include CBRE IM, Savills IM, and Resinova. This practice has been rare in the commercial real estate industry over the past few decades, but it is likely to become more common in the upcoming year(s).
Although the current policy rate is relatively high, the five-year average remains below 2%. This has resulted in delayed effects on various aspects, such as bankruptcy rates, unemployment rates, and vacancies.
At Carousel, we provide consultation services to commercial landlords, helping them navigate the rapidly changing market. We offer guidance on asset optimization and management, including strategies, development, and leasing.
