Can Ireland's Property Sector Contain The Banking Contagion?

Dublin’s real estate market was already braced for the impact of refinancing woes this year, as cheap debt comes to an end for many borrowers and property owners scrabble for affordable deals at a time when occupancy is dipping and valuations are dropping. That has been exacerbated by the turmoil in the global banking sector over the past month.

The Irish government has insisted that the domestic banks have been stress-tested to make sure they are ready for such a financial crisis, but right now the real estate industry is on standby, waiting to see how the events play out.

Here's a look at how the banks and real estate’s major asset classes are set to fare.

The Banking Sector
Irish bank shares have been on their own rollercoaster ride this month after the high-profile bank failures prompted waves of selling as the market digested the collapses of SVB and Credit Suisse, followed by worries about the stability of Deutsche Bank and other regional American banks.

Ireland's two biggest banks, AIB Group and Bank of Ireland, have said that they expect commercial real estate values to drop this year but believe that conservative underwriting will make any revaluation manageable.

"From our perspective, we consider what are the qualities of the underwriting and the quality of that underwriting is really, really robust with loan to value ratios in the order of 60% at initiation of the facilities," AIB CEO Colin Hunt told RTE. "So certainly I think that a valuation challenge may well be ahead for the sector, but I don't expect material impairments on foot of it."

Bank of Ireland, the country's largest lender by assets, has based its updated financial targets on commercial real estate price falls of 6% in 2023 and 2.5% in 2024.

Ratings agency Moody’s has maintained its positive outlook on Irish banks, and it has endorsed the system’s capital strength and liquidity levels. It added in its Irish report that profitability was set to improve as European Central Bank interest rates rise, allowing banks to reprice loans while keeping deposit costs low, improving margins.

The system is also resilient to tightening monetary policy, with a surplus of deposits and strong balance sheet structures, Moody’s said, pointing to rising real gross domestic product growth, declining inflation and historically low unemployment as economic bolsters.

While loan quality is expected to deteriorate, the agency said loan loss reserves at the banks will be able to absorb impairments and loan book growth — mainly from acquiring portfolios from Ulster Bank and KBC — should offset any hit to the bottom line.

Commercial Real Estate
Dublin’s commercial real estate landlords have been on tenterhooks ever since global tech companies started to lay people off amid the wider economic downturn. Job losses in Ireland have not been huge as yet but nonetheless they have affected confidence in a market overly reliant on the digital sector.

Professional services companies have compensated for some of the shortfall in office take-up, but among those are many that count the tech giants as key customers and some of them have also started to reduce headcounts. On top of that, work from home continues to impact office use, with just 10% of office capacity taken up on Fridays according to a report by Savills and Dublin Chamber.

Low levels of investment in offices are also down to a lack of prime office space, Colliers Head of Capital Markets Michele McGarry said, with investors less interested in secondary offices, as occupiers’ flight to quality office space continues.

“It’s not that there isn’t appetite for offices, but that investors are generally seeking prime assets with strong ESG credentials, and these assets are generally not available for investment,” she said. “There is a pipeline of new offices, but they have not yet hit the market and with the rise in gray space they may be slower to find tenants.”

Life insurer Irish Life, part of Canada's Great-West Lifeco, introduced a six-month notice period for withdrawal requests from a €500M property fund recently, citing an increase in the level of customer withdrawals.

BNP warned in its market update for the fourth quarter of 2022 of a more challenging year for commercial real estate, with vacancy rates likely to peak at about 15% later in 2023 compared with 12.5% last year, it reported.

While BNP Director of Research John McCartney said that those figures are not dramatically out of kilter with longer-term trends, he warned that around an 11% vacancy rate is typically the “tipping point” for rents to start trending downward.

However, unlike the previous huge crash in real estate, which contributed to the banking collapse, funds investing in property now play a key role, as opposed to highly leveraged developers, holding around 35% of the investible market, according to Bank of Ireland.

Residential
Dublin’s residential sector is not only the talk of the town but an increasingly complex conundrum. There is not enough housing and international companies have openly cited the lack of available accommodation as a blocker in attracting talent.

Meanwhile, residential developers are loath to unlock their land banks when construction costs are heading skywards and material and labour costs are highly volatile, making predictable returns on investment almost impossible to assess.

They have been calling for government help, while a report for the Land Development Agency said state bodies are sitting on enough sites to build almost 67,000 new “affordable” homes on public land in Dublin, Cork, Limerick, Waterford and Galway among others.

The agency’s assessment quantifies property assets held by public bodies that can be deployed for housing and showed that there is enough land in state ownership to deliver more than a quarter of the apartments and houses needed to meet the deficit of 250,000 homes set out recently by Taoiseach Leo Varadkar.

“The fundamentals are not in doubt because demand continues to outstrip supply," CBRE Director Colin Richardson said of the private rental market.

"However, there will likely be a higher proportion of standing product transactions, as opposed to forward-fund and forward-commitment deals. Yield expansion or pricing declines combined with elevated input costs will put pressure on structuring these trades.”

A total of €2B was invested in the residential sector in Ireland in 2022, with more than 70% of this capital focused on multifamily housing stock in the Dublin region, according to adviser CBRE. Dublin apartment completions in Q2 and Q3, many delivered with the support of institutional capital, failed to keep up with demand, and the cumulative undersupply is unlikely to be rectified in the near or medium term.

But investment and financial turmoil has seen a number of schemes stalled or withdrawn, and CBRE said that the viability of new apartment development is a key concern for 2023.

Retail And F&B
Despite the wider demise of retail across the nearby UK, in Dublin the retail centre has remained remarkably robust and new entrants to the city are mopping up vacant space.

What could derail the recovery is less likely to be further online erosion, with a relative rebalancing since the rapid e-commerce gains since the pandemic restrictions ended. Instead, the issue is the ongoing cost-of-living crisis and its impact on discretionary spend.

There have been some positive signs. Retail sales rose again in February as Irish shoppers bought slightly more last month, with retail volumes up 0.7% in February compared with January, according to the Central Statistics Office and 3.6% compared with February 2022.

Volume sales have now risen in the first two months of the year, after a 1.4% decline last November, followed by flat sales over December.

The CSO said spending in bars had surged almost 13% in February, but sales still remained significantly below pre-pandemic levels.

There have been some blows, such as the closure of Ireland’s remaining Argos chain. However, overall Dublin seems to have absorbed most of the retail pain from online and the pandemic, with a flagship Sports Direct to replace the vacant Debenhams.

Industrial & Logistics
Ireland’s insatiable thirst for industrial and logistics space has so far remained unchecked. Speculative space is disappearing fast, with most of the current development pipeline already pre-let and rents are already heading upward because of both demand and soaring and unpredictable building and energy costs, leaving the sector increasingly concerned about just how the pipeline can be brought up to speed.

Although the forecast for completions for 2023 is at an all-time high of 2.6M SF, the challenge facing the industry now is whether rising debt costs and the resultant impact on yields could hit the delivery of speculative units.

Currently there is demand of more than 2M SF for logistics buildings of 100K SF or larger, according to Savills Ireland. Of this demand, 63% is from retail-focused, first-party logistics firms and 20% is from third-party logistics firms.

“In terms of the pipeline, it’s almost completely pre-let," Savills Director of Industrial & Logistics Jarlath Lynn said. "Given the level of demand, for the past few years the Irish industrial and logistics sector has been playing catch-up, and now rising building costs have caused a little bit of havoc in the market. So the approach now is likely to be more measured, while developers try to get more predictability about the output yield.”