Commercial Real Estate: Strengthening Online Sales and Working from Home Will Significantly Impact Price Movements

The commercial real estate market in Croatia has not been a major source of systemic risks so far, and its importance compared to the residential real estate market from the perspective of the stability of the domestic financial system has been significantly lower, according to the latest analysis by the Croatian National Bank. However, since it cannot be ruled out that under certain circumstances the accumulation of systemic risks related to movements in this market could potentially threaten financial stability, the CNB is continuously working on improving the processes of their identification and monitoring and has begun collecting additional data on movements in specific segments of this market. Similar to residential real estate, unsustainable movements in the commercial real estate segment have historically been associated with numerous financial crises.

The reason lies in their strong connection with real movements and relatively inelastic supply of such properties, and in some cases, with the strong influence of international capital on this segment of the real estate market. For these reasons, the identification and assessment of systemic risks related to the commercial real estate market is an important part of the overall analysis of financial stability in a given country. In this context, their analysis, in addition to relevant data from the CNB and the DZS, is also based on additional indicators of the commercial real estate market collected from market participants. These indicators are available for a short period that does not cover the entire economic cycle and primarily relate to Zagreb and its surroundings, which constitute the most liquid segment of this market and for which agencies have reliable data.

Bank Exposure is Key

As the most important channel of influence of commercial real estate on financial stability, the exposure of credit institutions to this sector is highlighted, regardless of whether it is exposure through approved loans or through collateral in the form of commercial real estate, especially in conditions of bursting price bubbles in this market. Data from domestic credit institutions regarding their exposures secured by residential and commercial real estate show that commercial real estate in Croatia accounts for less than one-seventh of total exposures secured by real estate.

Although this indicator was higher during 2019 and early 2020 compared to the average of the previous five-year period, it can be concluded that movements in this market have significantly less weight in the context of financial stability compared to movements in the residential real estate market and that during the observed period, systemic risks related to the exposure of credit institutions to this sector did not significantly increase. The relatively low level of systemic risks associated with commercial real estate in recent years has also been contributed to by relatively weak activity in this market and very stable price movements and yields in certain segments of this market. Similar to movements in the residential real estate market, after a continuous slowdown that began back in 2007, construction activity measured by the number of issued building permits for non-residential properties and the area of completed non-residential buildings has slightly strengthened in recent years. Despite this, it is still at nearly half the level compared to the period before the outbreak of the global financial crisis. Both in terms of the number of issued building permits for non-residential properties and the area of completed buildings, industrial buildings and warehouses dominate.

Hotels at the Top of the List

However, most of them were not built for commercial purposes, but were constructed by companies for their own needs, meaning they do not count as commercial real estate. In the period after 2015, the number of issued permits for hotels and similar buildings has increased, which is associated with good results from tourist seasons and the expected continuation of positive trends in that sector, while the number of issued permits for traffic and communication buildings, wholesale and retail trade buildings, and office buildings has mostly stagnated or decreased. Activity in the commercial real estate sector measured by the amount of sales transactions has also strengthened in recent years, according to data from one of the private agencies, with strong fluctuations between years.

Transactions in the hotel segment have intensified, making them the highest in both absolute and relative amounts in 2019. They were followed by office spaces, whose relative importance has varied over the years, while once dominant investments in retail spaces have significantly decreased. Sales transactions involving logistics centers were the least represented in most of the observed period. From 2017 to the first quarter of 2020, the share of vacant capacities in the office space market stabilized at a relatively low level of around 3 percent of total office capacities available for rent, after a strong increase in their quantity in the last post-crisis recession period. At the same time, the reduction and stabilization of the quantity of available office spaces led to a slight increase in rental prices only at the end of the observed period, regardless of whether it was office spaces of class A or class B, and available data on yields from investments in class A office spaces indicate their gradual decline.

In the first quarter of 2020, the main source of demand for office spaces in Zagreb was the information technology sector, for whose employees 56 percent of the space rented in that quarter was leased, followed by activities related to business consulting and finance. The availability of vacant spaces for rent for retail purposes has generally slightly decreased until the end of the first quarter of 2020, averaging around 4 percent for segment A and around 11 percent for segment B at the end of that period. Yields for segment A remained unchanged at around 7 percent, and rental prices were also relatively stable. In contrast, rental prices for segment B recorded a slight increase during the observed period.

Little Investment Due to Bureaucracy

The industrial real estate and logistics center market is the least developed segment of the domestic commercial real estate market. The supply of warehouse spaces is very limited and mainly relates to older buildings, while the supply of new spaces is extremely small. This is, according to market participants’ assessments, partly a consequence of administrative barriers and high utility fees charged per cubic meter rather than per square meter, which discourages investments in the construction of such types of facilities. For these reasons, the logistics space segment is characterized by very low availability of vacant capacities for rent, which is around 3 percent, and rental prices and yields are higher than in comparable countries. Trends that have been present in this market for a long time, which have been further accelerated by the coronavirus pandemic, such as the strengthening of online sales and the increasingly frequent practice of working from home.

Such changes in people’s behavior inevitably affect almost all segments of the commercial real estate market, and thus could potentially cause problems for some participants in this market in meeting their obligations. Working from home, which marked most countries during the period when strict epidemiological measures were in place, was very poorly represented in Croatia before the pandemic. However, initial analyses conducted by agencies dealing with commercial real estate indicate a significant change in attitudes towards such a way of working from the perspective of employers and employees. Therefore, it can be expected that some employers will continue this practice to a certain extent in the future. Additionally, the earthquake that damaged part of the office spaces also affected the office space market in Zagreb, leading to increased market activity shortly after the earthquake due to heightened demand for offices in safer buildings.

Stronger Demand for Logistics Centers

During the quarantine period, the process of “transition” to online purchasing significantly accelerated. Assuming that some users will retain this habit even after the normalization of living conditions, further growth in demand for logistics spaces can be expected, consequently strengthening investment activity in that segment, along with a possible decrease in demand for retail spaces. Tourism is one of the sectors most affected by the consequences of the coronavirus pandemic, and due to uncertainty about its duration and intensity in the coming year, increased caution among investors in hotels and similar buildings is expected, which could lead to a decline in investments in that sector compared to previous years.

Analysis of available data shows that physical indicators from all observed segments of the commercial real estate market have been relatively stable in the past period, so it can be concluded that there has been no excessive price growth in this market segment and that the level of systemic risks associated with movements in this market has not significantly changed. Similarly, viewed from the perspective of credit institutions, their level of exposure to commercial real estate under such conditions also does not represent a significant systemic risk, concludes the CNB analysis. 

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