Box C: The New Zealand commercial property sector and financial stability
This page contains information on the New Zealand commercial property sector and financial stability from the November 2014 Financial Stability Report.
The commercial property stock has an estimated worth of around $180 billion, approximately one quarter of the value of residential property.1 Lending to commercial property investors tends to be relatively high risk and, as a result, accounts for approximately 20 percent of banks’ risk-weighted assets (compared to actual bank lending of just less than 10 percent). Commercial property loans have typically been the main source of loan losses during past financial crises, as highlighted by the experience of the Japanese and Nordic crises in the early 1990s, most economies during the GFC, and in New Zealand and Australia during the late 1980s.2
The tendency for higher losses on commercial property loans can be explained by large swings in values throughout a typical commercial property cycle. High average values, heterogeneous buildings, and significant transaction costs all contribute to the low average liquidity of the market, which can dry up further when the market weakens. New developments are also large relative to the existing stock and are subject to long build times. This generates direct risks for developers and their financiers, since a deterioration in market conditions during construction could render the project unprofitable. An overhang of supply can develop, exacerbating any price downturn and posing additional risks for landlords.
Non-performing loans in New Zealand increased in the commercial property sector in the wake of the GFC, although bank losses were contained relative to the late 1980s experience. Losses on commercial property lending were more substantial for finance companies, particularly related to exposures on higher risk – or mezzanine – tranches of property development loans, where the finance company did not have the first claim on the underlying security in the event of default. The share of non-bank lending to the sector has declined from around 20 percent in 2007 to less than 2 percent following the contraction of the non-bank sector in recent years. As a result, there has been a structural change in the amount of leverage available for property development loans.
Commercial property investors employ a range of business models (table C1). Based on data from Statistics New Zealand’s Annual Enterprise Survey (AES), at least 66 percent of the commercial property stock is owned by investors, with the remaining stock held mainly by owner-occupiers.3 A large proportion of firms in the industry are investors with a small portfolio of commercial property. Smaller investors are also able to take a stake in high value properties, which might otherwise be beyond their financial resources, through investment vehicles such as property trusts or syndicates. Investors with significant resources directly hold high value office/retail properties. This includes private equity (typically high net worth individuals or families) and institutional investors, sometimes from overseas.
Table C1: Indicative description of investors in the commercial property market
|Investor||Description||Share of assets (%)||Leverage (% of assets)||Involved in development?|
|Owner-occupiers||Corporates or small businesses owning their own premises.||≤34||Unknown||No|
|Small investors*||Own 1-3 properties, generally in small scale retail and industrial property.||≥59**||≤25**
(LVR at origination capped at 60)
|Private equity*||Domestic and offshore individuals active in the ‘core’ commercial property market, particularly large office and retail space.||Yes|
|Institutional investors (excluding LPTs)*||Pension funds, wealth management firms, both domestic and offshore, typically invested in prime grade property.||No|
|Listed property trusts (LPTs)||Pool investors’ funds and hold a portfolio of large properties, often diversified across sectors and regions. Listed on NZ stock market.||6||35
|Syndicates||Pool individual investors’ funds but, unlike trusts, typically hold a single property rather than a diversified portfolio.||1||40
Source: Bloomberg, interest.co.nz, Statistics New Zealand Annual Enterprise Survey, RBNZ SSR.
* All these categories will often hold assets in unlisted property trusts. These are typically not available for investment by the public, with trusts owned by some managed funds being the main exception.
** Implied by subtracting assets and debt of listed property trusts and syndicates from the overall assets and debt in the commercial property industry.
Sales volumes and prices of commercial property have increased in recent years. Around half of the value of recent sales has been in the market for high value properties in Auckland and Wellington, which are regularly monitored in the FSR using data from Jones Lang LaSalle (JLL). Larger investors, such as listed property trusts (LPTs), private equity, other institutional investors, and offshore investors, account for the majority of sales activity in these markets (figure C1). Domestic private equity and LPTs have both been relatively active and have together accounted for around 35 percent of purchases in recent years. Offshore investors have also accounted for a relatively large and growing share of purchases, seeking the relatively high yields on offer in the New Zealand commercial property market (in a climate of very low yields on assets in much of the rest of the world in recent years). Meanwhile, domestic institutional investors, outside the LPT sector, have been reducing assets. The recent sale of an AMP portfolio valued at more than $1 billion to a Canadian pension fund was a key driver of both these trends.
Figure C1: Commercial property transactions by entity (percent of total value traded)
Note: Only sales valued at $5 million or more are included. ‘Other’ includes corporate owner-occupiers, government and sales where the buyer classification was unknown.
With the commercial property market embarking on a new cycle, investor balance sheets are in a much stronger position than prior to the GFC. Aggregate debt as a share of earnings increased significantly in the wake of the GFC, as earnings declined, some commercial property investors drew on credit lines, and borrowing for late-cycle construction projects continued (figure C2). Debt-to-earnings has since declined, alongside reduced sales activity and property prices, and as some indebted investors exited the market. Declining interest rates and an increase in earnings since 2012 have also driven an improvement in interest cover ratios. There is limited information on the distribution of debt within the commercial property sector. In the LPT sector, where good data are readily available, debt-to-income ratios and interest cover ratios have improved since 2007.
Figure C2: Debt-to-earnings and interest cover ratios for commercial property investors
Source: Bloomberg, Statistics New Zealand Annual Enterprise Survey.
Note: Earnings are before interest and tax.
Development activity is beginning to increase, particularly in the office sector, in response to rising activity and values. With the lack of mezzanine finance reducing leverage available for property development, this supply pipeline is mostly being funded through wealthy private equity investors or LPTs – with significantly more equity than their counterparts prior to the GFC. This increase in equity buffers, along with the exit of riskier deposit taking finance companies from the sector, has reduced the direct risks to the financial system associated with development lending. The scale of the supply pipeline is also forecast to remain well below that seen prior to the late 1980s crisis and the GFC. The Reserve Bank will continue to monitor for any signs of growing risks in the commercial property sector.
1 Commercial property includes retail (restaurants and shops), accommodation buildings, office buildings, and industrial space (factories and warehouses). The reported figure is based on the total value of property reported by firms in Statistics New Zealand’s Annual Enterprise Survey, as of the year to June 2013. The figure excludes nonmarket property, such as schools and other government holdings of land.
2 Kragh-Sorensen, K and H Solheim (2014) ‘What do banks lose money on during crises?’, Norges Bank Staff Memo, 2014/03.
3 The AES only identifies assets as being held by commercial property investors if this is the primary purpose of the entity. Thus, in addition to owner-occupiers, the remaining 34 percent is likely to capture entities, such as some financial institutions, who may directly own commercial property for investment purposes.