Financial Stability Experts at the Fed Turn a Wary Eye on Commercial Real Estate

Interest Rates Increase

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The Federal Reserve's report on financial stability raised concerns about rising interest rates in commercial real estate.

5:35 p.m.

Federal Reserve financial stability specialists are looking for weaknesses following a year of increasing interest rates. As they assess the risks facing the system, experts are paying more attention to office loans and commercial real estate lending.

Fed officials raised borrowing costs quickly over the last year, from near zero in early 2022 to just over 5 percent. This was done to slow down inflation and to slow the economy. The banking sector has seen the most immediate impact of this abrupt change. In recent weeks, a number of prominent banks have faced difficulties or collapsed because they weren't prepared for higher borrowing costs.

The Financial Stability Report of the Federal Reserve Bank, released on Monday, cites commercial real estate among other areas worth monitoring.

In the report, Fed staff noted that the 'risk' of commercial borrowers not being able to refinance loans at the end their terms has increased.

The report stated that 'the magnitude of a property value correction could be significant and could therefore lead to credit loss by holders of C.R.E. The report noted that many of these holders were banks and smaller banks.

The Federal Reserve has intensified its monitoring of C.R.E. The report stated that the Federal Reserve has increased its monitoring of C.R.E. Concentration risk', the report stated.

The Fed's comments about commercial real estate were more of a tempered caution than a warning, but they came at a moment when investors and economists closely monitor the sector. Wall Street is particularly concerned about the outlook for downtown office buildings, where workers are still not back to full capacity after a shift in remote work during the coronavirus epidemic.

This report includes a survey of professionals from broker-dealers and investment funds as well as research and advisory organizations and universities. The respondents ranked commercial property as their fourth biggest concern for financial stability, behind the risks of interest rate increases, stress in the banking sector, and U.S. China tensions. However, they ranked it ahead of Russia's conflict in Ukraine and upcoming fights in Congress over raising debt limits.

The report stated that'many contacts saw real-estate as a potential trigger for systemic risks, especially in the commercial sector where respondents raised concerns about higher interest rates, valuations, and changes in end-user demands'.

In its stability report, the Fed also focused on the risks that the recent turmoil in the banking sector could pose to the economy. Many officials worry that this might cause banks to withdraw their lending. Fed survey of bank loan officials released on Monday revealed that the demand for loans of all types has declined in recent months. Borrowing is also becoming more difficult.

The Fed report stated that worries could lead banks and other financial organizations to further reduce the credit supply to the economy. A sharp reduction in credit availability would increase the cost of financing for households and businesses, possibly resulting in an economic slowdown.

The Fed report warns that if banks withdraw in a drastic way, this could have knock-on consequences.

The report stated that 'with a decline of profits in non-financial business, financial stress and defaults could increase at some firms', particularly because many companies are heavily indebted, which places them in a worse position if things go wrong.