Why are the commercial and the residential real estate markets moving in opposite directions?

Real estate takes many forms, such as a place of business, for touristic purposes, and as a store of value, to name a few. It also impacts associated industries like building insurance, construction materials, air conditioning, cable, and furniture.

Demand in the residential market is mainly driven by population growth, household formation, employment and income growth.

• The population of Cyprus increased by 85,000 from 2011 to 2021 and by circa 30,000 during 2022,
• Households are becoming smaller as fewer people are getting married and having children (Cyprus has one of the lowest fertility rates in the world; 1.3 births per woman compared to 2.1, which is the rate at which a population exactly replaces itself from one generation to the next, without migration), and
• The employment rate averaged 68% from 2000 until 2022, reaching an all-time high of 73% in Q3 2022, slightly lower that the EU average of 75%.
• Income growth averaged 2.2% from 2004 until 2022, reaching an all-time high of 8.3% in Q1 2022 (albeit growing less than the rate of inflation).

Supply of residential properties is driven by existing home inventory, new construction, and land availability. In Cyprus, construction of new homes has remained at low levels, both due to the economic crisis of the past decade and the lockdowns during the pandemic. Availability of land remains low, as most owners prefer to defer selling or developing their properties; as there is low taxation on owning real estate, many see it as a simple way to invest their capital deferring development or sale.

Growing demand for residential real estate and limited supply have pushed up real estate prices and rents, fuelled further by low interest rates over the past decade and government subsidies during the pandemic. The low cost of funding made housing affordable for many, something which is quickly uncoupling in the current inflationary and high(er) interest rate environment.

Demand for commercial real estate is driven by a strong economy, employment growth, and consumer spending (especially affecting retail). The Cyprus economy has grown significantly since the end of the pandemic (5.8% GDP growth in 2022), particularly due to a pick-up in tourism, attracting technology companies to the island, and immigration/ population growth.

On the supply side, there has been minimal construction of sizable retail or warehouse space, whilst supply of offices has been concentrated in a handful of projects in Limassol and to a lesser extent in Nicosia. As the pattern of office usage and retail spending have changed, there are obvious pockets of excess supply and limited demand across the commercial real estate market, e.g. for grade B/C offices in Nicosia vacated by banks, secondary retail locations in Paphos and Larnaca as retail spending has shifted to the malls, etc.

The main change over the past year has been the cost of funding for developers and investors, and the improvement in alternative options available for investors. Whilst companies coming to the island or expanding their operations currently have limited options, investors of income producing commercial real estate are agnostic as to where to channel their capital. With higher income returns available on government and corporate bonds and a higher cost of financing to acquire real estate, most investors are demanding higher returns from real estate to reflect these higher costs as well as the changing patterns in office use (due to work from home) and retail (due to online shopping). This is already reflected in the performance of listed European REITs (Real Estate Investment Trusts), where their value has decreased by circa 43% over the past year.

In conclusion, the residential and commercial real estate markets are moving in opposite directions due to differences in demand, supply, and pricing factors. The residential market is experiencing growing demand and limited supply, leading to increased prices and rents. In contrast, the commercial market faces challenges due to changing patterns of office usage, retail spending, and financing options.

Looking ahead to 2024, residential real estate prices and rents are unlikely to shift significantly, but demand may decrease due to higher prices and the increased cost of funding. Local households will struggle to enter the housing market. In the commercial sector, the limited supply of investor-ready properties will likely decrease as better investment opportunities emerge elsewhere. This will result in increased illiquidity, particularly if international investors demand higher returns from commercial properties.