The commercial property sector is "vulnerable" to the Covid-19 crisis and banks have a $40 billion exposure, representing about 8 per cent of all lending.

Reserve Bank Governor Adrian Orr today released the May Financial Stability Report which said that hotel, retail and some office properties had been immediately hit by international travel restrictions and alert level 4 measures.

"The commercial property sector is vulnerable to the COVID-19 crisis. Commercial property has historically been a source of significant credit losses for banks, including in New Zealand. Banks' total exposure to commercial property is around $40b, representing 8 per cent of total bank lending, with around $5b of this related to property development," the report said.

In recent years banks had tightened lending standards to the sector, the report said, citing pre-sale requirements, loan to value ratios and banks have applying increased scrutiny around the quality of construction companies.

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"Overall, this has improved the quality of bank lending to the sector," the report said.

Problems in the commercial property sector were therefore unlikely to threaten financial stability on their own, but could exacerbate the downturn and weaken the financial system's resilience.

"Many property owners had proactively offered rent reductions to support tenants during the downturn, but a prolonged economic slump will put downward pressure on rents and lead to increases in vacancy rates," he said.

Current development pipelines also indicate that an above-average volume of retail and accommodation space is due to be delivered over the next 12 months in the Auckland and Queenstown markets.

Demand may therefore struggle to keep pace with this increased supply, and the viability of some commercial property loans will be called into question and the financial system is exposed to risks in the sector.

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Many commercial property sector characteristics contribute to its cyclical nature.

"Many investors are leveraged, with significant maturity mismatches on their balance sheets, and rely on rental income to service debt. Investors also tend to have relatively undiversified portfolios, and face single-tenant risk," the report said.

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Commercial property yields had fallen significantly lately. But yield compression often signals increased risk tolerance, and heightens the risk of a price correction.

Much of the recent yield compression, however, could be attributed to the fall in long-term interest rates. Risk premiums for commercial property have remained relatively stable in recent years, suggesting that commercial property was not overvalued relative to other asset classes prior to Covid-19.

"Covid-19 might accelerate longer-term trends in the commercial property sector. Occupier demand for retail space may be permanently stunted as social and physical distancing measures accelerate existing trends towards online shopping. For office space, the recent experience of remote working may encourage firms to extend their flexible work arrangements, decreasing demand," the report said.

The Australian media has reported how almost A$50b could be wiped from the value of commercial office properties across that country's major cities as a surge in the number of work-from-home staff forces employers to reassess how they operate their businesses and dampens demand for a corporate footprint in central business districts.

Property analysts predict the value of the nation's office tower sector — currently estimated at $318bn — could fall by as much as 15 per cent over the next year because of the shift away from highly centralised CBD operations to stay-at-home work.

Mark Lister of Craigs Investment Partners said commercial property values were largely a function of rents and interest rates.

Interest rates had moved in favour of stable or higher valuations but rents would come under pressure like they do in every recession as demand falls on the back of businesses facing challenges, and some being forced to reduce staff and downsize, Lister said.

"When you throw in a structural change in working habits and behaviour, such as an increase in flexible and remote working, then that is likely to reduce the demand for office space further, thereby putting additional pressure on rents as landlords are forced to work harder to fill vacancies," he said.

All of that was clearly a negative for office property values, and potentially rental income. At the very least, it will limit any rental growth, Lister said.

"It's difficult to quantity just what any impact might be, but I suspect many businesses will, post-Covid, have a much more open-minded approach to flexible working, partly because it keeps staff happy and improves productively, and partly because reducing office space is a cost-effective measure for a business to take," he said.

The very top end office property will be fine, but smaller, lower quality buildings might suffer more, Lister said.

Frances Sweetman of Milford Asset Management said structural changes driven by the pandemic and working from home would take time to hit demand for office space, but would dampen demand over the longer-term.

"This will reduce rent growth which will have some impact on valuations but the near-term cyclical impacts are a greater concern. There is little evidence of that yet so office values will be stable for a while but expect downward pressure over the next six to 12 months with prime assets being a lot more resilient," she said.