- The possibility of large losses in the $24 trillion U.S. commercial real estate market poses a top risk to financial stability, the Federal Reserve said, noting rising vacancy rates and slowing rent growth.
- “A correction in office property valuations accompanied by even a mild recession could result in significant losses for a range of financial institutions with sizable exposures, including some regional banks and insurance companies,” the Fed said in its quarterly Financial Stability Report.
- Three out of four analysts at financial services firms ranked real estate as the top threat to financial stability, tied with inflation and a jump from fourth place in May, the Fed found in a survey. “There will be losses for sure,” Fed Chair Jerome Powell said in an interview on Thursday. “You can drive down through most downtowns — many downtowns anyway — and see buildings that are empty.”
The commercial real estate market has slumped in recent years as working from home grew in popularity and borrowing costs surged.
Since March 2022 Fed policymakers, aiming to slow the worst inflation in four decades, raised the benchmark interest rate from near zero to a range between 5.25% and 5.5%, a 22-year high.
Meanwhile, prices for commercial properties fell 3.9% from the second quarter of last year to Q2 2023, well below the 3.3% average annual growth from 1997 until Q2, the Fed said.
Commercial real estate “valuations are particularly elevated for the office sector, where fundamentals are especially weak for offices in central business districts, with vacancy rates increasing further and rent growth declining since the May report,” according to the Fed.
Banks reported an increase in standards and falling demand for all categories of commercial real estate loans during the first half of this year, the central bank said, citing its Senior Loan Officer Survey.
“Commercial real estate is not a principal risk, or a major risk, for the largest banks,” Powell said in the interview. Regional and smaller banks “have proportionately much larger exposure to real estate.”
“What we've done is supervisors are in there looking at real estate portfolios, they're working with banks to make sure that they have plans to deal with the problems they have in their portfolios,” he said. “We’re on that case.”
Financial instability may also flare if price pressures persist and prompt the Fed to further tighten monetary policy, according to the broker-dealers, investment funds, research companies and other analysts at financial services firms surveyed by the central bank.
Following increases in the federal funds rate, many companies will need to refinance debt at much higher interest rates than were common just two years ago.
The outlook for borrowing has worsened in recent weeks, straining the balance sheets at some businesses.
Since policymakers met on Sept.19-20, the yield on the 10-year Treasury note has risen about 0.5 percentage points to 4.8%.
The yield — the benchmark for corporate bonds, auto loans, mortgages, student loans and other financing — breached 5% on Monday for the first time in 16 years before falling back. It began 2023 at about 3.8%.
“A sharp increase in rates could lead to heightened volatility in financial markets, stresses to market liquidity and an adjustment in asset prices,” the Fed said.