Federal Reserve issues warning about CRE values

The Federal Reserve is the latest body to weigh in on the potentially devastating impact the coronavirus pandemic could have on commercial real estate markets nationwide.

In a 70-page Financial Stability Report issued late last month, the Board of Governors of the Federal Reserve System noted that commercial real estate values — especially in sectors like hospitality and retail – could face a significant correction because of COVID-19.

“Price declines could be especially pronounced in areas where valuations have remained high and where asset values are sensitive to the pace of economic activity,” the Fed writes. “CRE markets are an example, as prices were high relative to fundamentals before the pandemic and the disruption in hospitality and retail sectors have been severe.”

The Fed notes that commercial real estate values rose by 8% nationwide between the fourth quarter of 2018 and the same three-month period in 2019, outpacing every traditional investment vehicle save for equities during the same period. The value of equities grew at a whopping 26.4% during the period. More typical was residential real estate, where values climbed 3.8%.

But the Fed suggests the industry faces a turbulent future.

“The vulnerability stemming from elevated CRE valuation pressures, coupled with a dim outlook for the sector as indicated by recent declines in equity real estate investment trust prices, suggests that CRE may undergo a substantial repricing in response to disruptions generated by the COVID-19 pandemic,” the Fed notes.

“Since late February, the hospitality and retail sectors have experienced precipitous declines in demand because of social distancing, putting the ability of these sectors to make timely mortgage and rental payments into question,” the Fed report adds.

At the same time, the report indicates that the commercial mortgage-backed securities market, which had been funding about one-fifth of all CRE mortgage debt, ceased new securities offerings more than two months ago.

As a result, “CRE loans that would normally be securitized have been accumulating on bank balance sheets.” Banks also have reported weaker demand for CRE loans and tighter lending standards.

Perhaps most unsettling, the Fed doesn’t predict that the after-effects of the virus could hamper economic growth well into the future.

“Strains on household and business balance sheets from the economy and financial shocks since March will likely create fragilities that will last for some time,” the Fed says.