Finally the Fed Says Something Positive About CRE

Federal Reserve Governor Lisa Cook, who recently became chair of the central bank’s Committee on Financial Stability, told the Brookings Institution on Wednesday that there is sufficient financial stability to withstand jolts from potential shocks. That includes from commercial real estate loans, she said.

The committee will “routinely monitor four broad sets of vulnerabilities to the financial system that could amplify shocks: household and business leverage; the use of leverage by financial institutions; the degree of maturity and liquidity transformation in the financial system, or, in plain English, ‘funding risk’; and asset valuations and risk appetite,” Cook said.

“In assessing these vulnerabilities, we tend to place a lot of weight on the capital adequacy and liquidity of the largest and most interconnected financial firms,” she added. “Currently, these firms appear well positioned to absorb a shock.”

That said, it doesn’t mean all is equally well. Conditions in regional banks have improved since the failures of several banks in the first quarter of 2023, when large depositors pulled in total large amounts of funding when they because concerned about the value of such assets as low-interest rate Treasurgys and mortgage-backed securities. When rates went up to fight inflation, the price of the items that had been purchased at much lower rates dropped sharply. Alarmed big depositors pulled out, leaving the trio of banks insolvent. Most institutions have “lowered their reliance on uninsured deposits” since then.

However, there is another source of widely held asset that has been badly affected by changing interest rates. Those are high concentrations of commercial real estate loans held by one group of banks. “Supervisors are working closely with the set of banks that have experienced outsized fair-value losses from higher interest rates and with banks that have high concentrations of commercial real estate loans,” she said.

Not that all CRE loans are automatically problematic. “Properties have been differentially impacted by changes in the way many people live, shop, and work,” said Cook. Suburban medical offices and CBD office buildings likely have far different occupancy rates. “Looking at broader trends, values of office buildings have been most affected by lifestyle changes, and values of multifamily properties have also dropped over the past year. These trends present challenges for property owners and lenders, who will need to manage those risks and make appropriate adjustments as the outstanding loans come due.”

In 2023 Q4, banks held something more than $3 trillion in outstanding debt backed by commercial real estate. CRE loans are about 5% of large banks’ total assets, but 30% of assets at smaller banks.

“Those high concentrations have caused us to step up our supervisory work with community and regional banks that have significant CRE concentrations and to augment our regulatory data for this sector,” Cooks said. “For instance, data available from SEC Form 10-Q filings suggest that office exposures account for a small share of most regional banks’ CRE loans. All told, I view CRE risks currently as sizable but manageable, and I will be paying close attention to the sector in the short and medium run.”