The Financial Stability Oversight Council has just issued its annual report on the risks to the US’ financial stability. One of the dangers it is concerned about is a collapse in the US commercial real estate market. 

The picture it paints is a dire one for CRE and not necessarily reflective of the view of many industry research teams. 

The FSOC notes, for example, “The shock to CRE has been large, with the hotel and retail sectors suffering the most significant near-term losses. Considerable uncertainty remains regarding the long-term recovery prospects for a wider range of property types.”

Potential losses in CRE could well spill over into the larger economy,  the FSOC went on to say. “Stress in CRE markets can exacerbate economic downturns because CRE debt represents a large source of credit exposure for the financial system–about $4.7 trillion as of the second quarter of 2020.”

The FSOC says that certain features of the current CRE financing environment may raise the potential for spillovers. One potential concern is that hotel and retail loans are concentrated in non-agency CMBS. Servicing frictions could drive distressed property sales, which may trigger price declines, according to the report. 

Another concern is that small and mid-sized regional banks are highly exposed to CRE, according to the report. If there are losses on CRE loans at these banks, it could drive a broader contraction in credit. The spillover effects of CRE loan exposure could hit areas that are more dependent on local sources of funding much harder.

These small- and mid-sized banks are more exposed to CRE than the stress-tested banks on average. In the second quarter of 2020, CRE accounts for about 40% of non-CCAR banks’ loan portfolios and about 10% of CCAR banks’ loan portfolios.

These smaller banks are also an essential source of credit to small business and retail borrowers. If they suffer losses on CRE-backed loans, it could drive a broad contraction in credit, particularly in the sectors of the economy that rely on local sources of financing, according to the report.

For large banks, the picture is a little brighter, but there are still concerns. Over the Federal Reserve’s stress tested large banks with a scenario involving a sharp contraction in the values of retail and lodging properties. It found the banks had enough capital to maintain the flow of credit, assuming a V-shaped recovery. 

However, under a more severe U or W-shaped scenario, several lenders would approach minimum capital ratios, which might result in a sustained tightening of underwriting standards or contraction of credit. 

Permanent Declines in Cash Flow 

The FSOC also is concerned that the cash flow declines for CRE assets in the last year could become permanent. 

The FSOC says that there is considerable uncertainty about which CRE sectors may recover completely following the pandemic and which sectors face permanent shifts in demand. It notes that the pandemic may have shifted trends toward online shopping, which could hurt the retail sector.

The long-term trends for apartments and offices are unclear, according to the FSOC. It notes that a permanent shift toward teleworking may reduce demand for office space and drive economic activity away from city centers where many apartments, retail, restaurants/food outlets, and offices are located. If there is a permanent shift to teleworking, demand could shift from apartments to single-family homes, according to the FSOC. 

But the FSOC notes that there may be a reversion to pre-pandemic business practices, which could reverse recent vacancy trends in apartments and offices. Downward changes in cash flows will lead to permanent declines in valuations in specific sectors. That will lead to losses for holders of CRE. 

In this scenario, though, the risk is mostly limited to the CRE industry, the FSOC says, “As long as these losses accumulate gradually, they are unlikely to trigger large disruptions to the financial system,” it concludes.