The Fed is starting to get worried about the $2 trillion commercial real estate market

Posted on February 16, 2017

The fear of what Fed Chair Janet Yellen on Tuesday – and other Fed governors earlier – called “waiting too long” before raising interest rates is increasingly inserting itself into Fed pronouncements. One of the aspects – and this is getting articulated with increasing intensity – is commercial real estate (CRE) and its impact on banks whose nearly $2 trillion in CRE loans are backed by collateral whose boom-prices are known to crash periodically in phenomenal busts.

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Or is it the fear of “having already waited too long?”

Boom and bust: that’s the material CRE is made of. We had seven years of boom, and now the Fed is worried about the bust. Yellen didn’t mention CRE in her prepared testimony on Tuesday before the Senate Committee on Banking, Housing, and Urban Affairs. But it featured in the twice-yearly report that the Fed delivered to Congress in support of Yellen’s testimony.

And it wasn’t the first time that it was mentioned in these twice-yearly reports – but the fifth time in a row.

In its February report two years ago, the Fed first pointed at “valuation pressures” in CRE. And warnings about CRE have appeared since then in every report, twice a year, with growing sharpness, including in the report issued in June 2016, which warned that  “valuations in the CRE sector appear increasingly vulnerable to negative shocks….”

Other Fed governors have also warned about the CRE boom and a potential bust, particularly Boston Fed governor Eric Rosengren, who was gazing with amazement at a stunning crane forest in his own city.

What concerns the Fed about CRE aren’t the valuations per se, but the fact that the sector is highly leveraged, and that when prices collapse, which they tend to do, the collateral value gets crushed, and banks are left to twist in the wind. That’s what happened during the Financial Crisis.

Just how badly can prices get crushed? The national averages hide the drama that happens on the ground in particular cities. But even these national averages still show enough drama, as per data from the Green Street Commercial Property Price Index. The index shows that overall prices across the major markets in the nation plunged nearly 40% during the Great Recession and have since more than doubled:

So that’s why the Fed is fretting about it. This time around, the Fed report said:

Commercial real estate (CRE) valuations, which have been an area of growing concern over the past year, rose further, with property prices continuing to climb and capitalization rates decreasing to historically low levels.

Then the report discusses the debt that nurtured this boom to these heights. This debt has ballooned to $1.98 trillion, and is now 14% higher than during the crazy peak of the prior bubble that collapsed with such spectacular results:

The Fed is careful not to sow panic among bank investors. So it couches its message in a big “while” and some other mollifying words, before getting to the meat at the very end of its long sentence, namely that a “sizeable” decline in CRE prices could take down “smaller banks”:

While CRE debt remains modest relative to the overall size of the economy and the tightening in bank lending standards for CRE loans in the second half of last year may reflect some reduction in the appetite for CRE lending, the heightening of valuation pressures may leave some smaller banks vulnerable to a sizable CRE price decline.

And “smaller banks” are precisely what’s the most on the hook: they hold about $1.22 trillion of these CRE loans.

But the national averages hide what is happening in individual cities. Some markets are still rocketing higher, but others have shot craps, particularly Houston, whose CRE market has beenslithering into deep trouble for well over a year. New York City is having its moment. And San Francisco’s office leasing market has just had the worst year since 2009. They’re among the large markets where the dynamics have already flipped. Other markets will fall in line behind them.

Boom and bust – that’s the nature of the sector. Only this time, historically low interest rates for eight years and the resulting wild chase for yield among desperate investors have created the most magnificent CRE bubble ever with the most leverage ever. And I have no idea how the Fed is going to unwind its handiwork softly without pulling the rug out from under the banks and CRE investors.