Fed Reports Show an Increasing Focus on CRE
May 15, 2023
Commercial real estate borrowing was highlighted as an area of concern in the Federal Reserve Board’s twice-annual Financial Stability Report, released last week.
Why it matters: With a particular emphasis on office loans, the report noted the shift towards telework and the resulting correction in valuations for office buildings. Exacerbating the problem is the rising interest rate environment which has increased the risk of borrowers not being able to refinance their loans, potentially leading to credit losses for holders of CRE debt.
The report included a survey of 25 professionals at broker-dealers, investment funds, research and advisory organizations, and universities.
- Those respondents ranked CRE as their fourth-biggest financial stability concern, after risks from interest rate increases, banking sector stress, and U.S.-China tensions, but ahead of Russia’s war in Ukraine and an impending fight in Congress about raising the debt limit.
- Some market participants associated risks in real estate with the emergence of banking-sector stress, noting some bank exposures to underperforming CRE assets could prompt instability.
In its discussion of valuation pressures facing CRE, the report indicates they remain at high levels.
- Aggregate CRE prices measured in inflation-adjusted terms have declined, but this could mask growing weaknesses as more distressed properties are generally less likely to trade.
- Capitalization rates have turned up modestly from their historically low levels. Weaknesses in the office sector are especially pronounced for offices in central business districts, with vacancy rates increasing and rent growth declining.
Non-farm non-residential CRE mortgages tend to be a small share of total assets held by banks overall, as noted in the report, but some banks may have more concentrated exposures to CRE mortgages than average, leading to higher-than-average losses if CRE conditions weaken. To address these concerns, the Federal Reserve has increased monitoring of the performance of CRE loans and expanded examination procedures for banks with significant CRE concentration risk.
The Fed also released its survey of bank loan officers last week. The survey showed that demand for many types of loans has fallen in recent months, and it is becoming harder to borrow.
Worries could “lead banks and other financial institutions to further contract the supply of credit to the economy,” the Fed report said.