This Is Fed President Esther George’s Main Worry About CRE

CRE has fared very well during the pandemic, but it is important not to underestimate the support stimulus has given the industry, according to comments Fed President Esther George made in a speech yesterday. Her main concern for the industry/? When the support ends, many renters and businesses could find themselves unable to meet their obligations. This in turn would force banks to realize losses on existing loans which would then weigh down credit growth and broader economic activity.

“While it is important to acknowledge the role of policy in supporting the real estate market, it is also important to be aware of the forthcoming challenges when this support is withdrawn, especially against the backdrop of longer-term structural changes to the outlook,” she said. 

These structural changes have been well chronicled since the outset of the pandemic: WFH is driving huge changes in office demand, while suburbs become more favorable locations for both companies and renters. Office tenants are also increasingly favoring smaller footprints and shorter lease terms, and weighted-average lease terms are also slipping.

George drew parallels in her remarks to the lessons of the 2008 financial crisis, which she noted was linked to “excesses” in residential real estate financing.

“While the strains on real estate finance currently appear contained, this relative health has been importantly supported by the extraordinary policy response to the pandemic,” she said in her remarks. “If support fades ahead of a sustained recovery, stresses could become more prominent, especially against a backdrop of disruptive structural change.”

Cracks in the CRE façade could also endanger overall financial stability, she says, since a sharp downturn in the commercial property market can undermine banking systems. Of particular note: at the end of 2019, commercial real estate loans constituted more than 25% of assets held at small community banks, though George said credit performance “has held up reasonably well.” Delinquencies on loans secured by commercial property are “significantly lower” than experts expected at the outset of the pandemic, and George pointed to measures like expansion of the Term Asset-Backed Loan Facility (TALF 2020) to include certain commercial mortgage backed-securities, as well as “extraordinary measures” by the Fed and Treasury as direct reasons for that. 

On the borrower side, George says, initiatives like the Paycheck Protection Program, Main Street Lending, and enhanced unemployment insurance allowed tenants to keep paying rent. And for lenders, the programs provided capital and liquidity support to facilitate voluntary forbearance offers to distressed borrowers, she said. 

“Forbearance has been a significant contributor to improved metrics of CRE loan performance,” George said. “Still, market analysts predict that a significant volume of commercial loans currently in modification programs may ultimately default. Given this backdrop, a worrying scenario is that the economic impact of the pandemic outlasts the policy support programs currently in place.”