The Fed's Worst-Case Scenario Is CRE Doom

If you believe in the forecasting power of celebrity hair styles—in this case, “back to the office” powerbobs, as The Guardian put it—real estate is due for a good boost.

But coiffured optimism has a sartorial counterpart in banker’s gray. Specifically, the Federal Reserve announced its 2022 large bank stress tests, which include a recession scenario of 10% unemployment over two years, a 40% drop in real estate prices, and a collapse in other assets like corporate debt (speaking of back to the office).

No need to panic. This isn’t a prediction but a planning scenario to see if financial institutions are sturdy enough to withstand a financial crisis and it’s a result of the Dodd-Frank Act that came in the wake of the 2008 financial debacle. However, that isn’t the same as saying it’s all made-up and impossible.

As the Fed explains it, “the Federal Reserve projects balance sheets, RWAs, net income, and resulting post-stress capital levels and regulatory capital ratios over a nine-quarter planning horizon, generally using a set of capital action assumptions prescribed in the Dodd-Frank Act stress test rules.” There are three scenarios: baseline, adverse, and severely adverse.

The idea is to let regulators, banks, and the public know how well the financial system could cope with disaster and the results must be publicly disclosed by June 30.

You can guess in which category the asset collapse and surge in unemployment belong. Those are only parts of the scenario. There would also be a fast drop in GDP, a drop of more than 3.5% from the fourth quarter of 2021 to a trough in the first quarter of 2023. Inflation would spiral down from 8.25% at the end of 2021 (it was actually more like 7.5%) to 1.25% in the third quarter of this year and then up to 1.5%. 

The spread on yields between investment-grade bonds and yields on the 10-year Treasury would expand to 5.75 percentage points by the middle of 2022. Equities would drop 55% through 2022. House prices would lose 28.5% while CRE properties would lose 40%, mostly in “properties most at risk of a sustained drop in income and asset values: offices, hotels in urban locations or that cater to business travelers, shopping malls, and strip malls.”

In comparison, the baseline scenario would include unemployment dropping to 3.5%, GDP growth slowing to eventually land at 2% (the higher earlier values representing recovering from low levels of 2020), inflation ending at 2.25%, 10-year Treasury yields reaching 2.5%, and steady equity prices.

What is really of interest in the baseline scenario—where the Fed is betting the future is likely to lie—is how real estate does. Nominal (without considering inflation) house and CRE prices rise 3%. That means little actual value growth after inflation and possibly slight loss.

Because no matter who handles your wardrobe, even if you don’t lose your shirt, some buttons might go askew.