In its recently-released bi-annual Financial Stability Report, the Federal Reserve issued a grim warning that asset prices remain vulnerable to significant price declines should the pandemic take an unexpected course. One example in particular, it said, was commercial real estate.

CRE prices were already high relative to fundamentals before the pandemic, it noted, and disruptions in the hospitality and retail sectors have been severe.

"The vulnerability stemming from elevated CRE valuation pressures, coupled with a dim outlook for the sector as indicated by recent declines in equity REIT prices, suggests that CRE may undergo a substantial repricing in response to disruptions generated by the COVID-19 pandemic," it said.

As part of its analysis, the Fed noted that commercial property rents have generally risen more slowly than prices over the past several years. As a result, capitalization rates have ranged around historically low levels.

Now amid the economic disruption caused by the COVID-19, CRE's situation could well worsen. Already, 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 said.

It also observed that non-agency CMBS, which had previously been funding about one-fifth of CRE mortgage debt, stopped new securitizations toward the end of March and that CRE loans that would normally be securitized have been accumulating on bank balance sheets. Finally, it said, data from the April 2020 Senior Loan Officer Opinion Survey on Bank Lending Practices indicated that a major fraction of banks reported weaker demand for CRE loans and tighter lending standards, on net, in the first quarter of 2020.

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Fed Warns CRE May Undergo 'Substantial Repricing' Because of Pandemic Disruption

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