Financial stability experts at the Fed are suspicious of commercial real estate
Federal Reserve financial stability experts are looking for weaknesses after a year of rising interest rates – and as they map out the potential risks facing the system, they are increasingly looking at office loans and other loans for commercial real estate.
Fed officials have been rapidly raising borrowing costs over the past year — to just over 5 percent from near zero in early 2022 — to cool rapid inflation by slowing the economy. So far, the impact of this abrupt change has been most apparent in the banking sector. A string of high-profile banks have collapsed or faced turmoil in recent weeks, in part because they were ill-prepared for higher borrowing costs.
But Fed officials and market experts they poll cite commercial real estate as another area worth watching in the central bank’s biennial reports. Financial Stability Reportwhich was released on Monday.
The rise in interest rates over the past year “increases the risk” that commercial borrowers will be unable to refinance their loans when the loans reach maturity, Fed officials wrote in the report, noting that commercial real estate values continue to rise. “raised.”
“The magnitude of a correction in property values can be significant and can therefore lead to credit losses by holders of CRE debt,” the report said, noting that many of those holders are banks, and smaller banks in particular.
“The Federal Reserve has tightened monitoring of CRE loan performance and expanded investigation procedures for banks with significant CRE concentration risk,” the report said.
The Fed’s comments on commercial real estate have been a quiet vigilance rather than a full-throated warning — but they come at a time when many investors and economists are watching the industry closely. The outlook for downtown office buildings, where workers have not fully returned after a shift to remote working that began during the coronavirus pandemic, has become a particular concern on Wall Street.
The report included a survey of 25 professionals at broker-dealers, investment funds, research and advisory organizations, and universities, and which respondents ranked commercial real estate as their fourth-highest concern for financial stability — behind risks from rate hikes, stress in the banking sector, and tensions between the US and China, but ahead of Russia’s war in Ukraine and an impending battle in Congress over raising the debt limit.
“Many contacts saw real estate as a potential trigger for systemic risk, particularly in the commercial sector, where respondents expressed concerns about higher interest rates, valuations and shifts in end-user demand,” the report said.
The Fed’s stability report also focused on the risks to the economy that could arise from the recent turmoil in the banking sector, which many officials say could prompt banks to pull back when it comes to lending. A fed survey of bank loan officers released on Monday revealed that demand for many types of loans has fallen in recent months and it is becoming increasingly difficult to borrow.
Concerns could “lead banks and other financial institutions to further limit lending to the economy,” the Fed report said. “A sharp contraction in credit availability would drive up borrowing costs for businesses and households, potentially leading to a slowdown in economic activity.”
And drastic withdrawal of banks could have knock-on effects, the Fed report warned.
“With earnings of non-financial companies declining, financial stress and defaults could increase for some companies,” the report said, especially as companies are heavily indebted – which puts them in trouble when things go bad.