Federal Reserve financial stability experts are keeping a watchful eye on potential weaknesses in the economy following a year of rising interest rates. As they assess the risks facing the system, they are increasingly monitoring office loans and other commercial real estate borrowing, according to a recently released Financial Stability Report by the Board of Governors of the Federal Reserve System.
Over the past year, Fed officials have increased borrowing costs to just above 5 percent from near-zero in early 2022 to slow the economy and combat rapid inflation. While the banking sector has been hit the hardest by this abrupt change, Fed staff members and market experts have identified commercial real estate as another area worth watching.
The increase in interest rates raises concerns that commercial borrowers will be unable to refinance their loans when they reach the end of their term, particularly given that commercial real estate values have remained high. The report notes that a correction in property values could result in significant credit losses for holders of commercial real estate debt, including banks, particularly smaller ones.
“The magnitude of a correction in property values could be sizable and therefore could lead to credit losses by holders of C.R.E. debt,” stated the report.
The Federal Reserve has therefore ramped up its monitoring of the performance of commercial real estate loans and expanded examination procedures for banks with significant commercial real estate concentration risk.
Although the Federal Reserve’s remarks regarding commercial real estate are not an outright alarm, they arrive at a moment when numerous investors and economists are scrutinizing the industry closely. There is heightened apprehension on Wall Street about the future of office buildings located in downtown areas, where employees have not fully returned to work following the pandemic-induced shift towards remote work.
The report surveyed 25 experts from broker-dealers, investment funds, research and advisory organizations, and universities, who ranked commercial real estate as their fourth most significant financial stability concern. This ranking placed commercial real estate below risks arising from interest rate increases, banking sector stress, and U.S.-China tensions, but above Russia’s war in Ukraine and the impending debate in Congress about increasing the debt limit.
The report also focused on risks to the economy that might arise from the recent banking sector turmoil, which many officials are worried might prompt banks to pull back on lending. A Fed survey of bank loan officers showed that demand for many types of loans has fallen in recent months, and it is becoming gradually harder to borrow.
The Fed warns that a sharp contraction in the availability of credit could drive up the cost of funding for businesses and households, potentially resulting in a slowdown in economic activity. If banks pull back dramatically, it could also lead to a decline in profits of nonfinancial businesses, financial stress, and defaults at some firms, especially given their high levels of indebtedness.