The Fed Worries That Low Transactions May Mask Falling CRE Valuations

While commercial real estate valuations remain high, the Federal Reserve Board of Governors say low transaction volumes, specifically for distressed properties, may mask some declines in value. 

Overall, there was $20.9 trillion outstanding of commercial real estate. From Q4 2019 to Q4 2020, there was 7.4% growth in the sector. By comparison, the sector posted 5.7% growth from 1997 to 2020. 

The Fed says that disruptions caused by the pandemic make it hard to understand what valuations are in the CRE sector. While cap rates continue to decline, the Fed notes that an index of REIT properties remains below pre-pandemic levels. 

In addition, the Fed points to other uncertainties in the CRE sector that could impact valuations. For instance, it says vacancy rates continue to increase as rent growth is declining. Additionally, it points out that delinquency rates on commercial mortgage-backed securities remain elevated. Also, it cites the January Senior Loan Officer Opinion Survey on Bank Lending Practices, that showed banks reporting weaker demand for most CRE loans and tighter lending standards in the fourth quarter of 2020

In other sectors of real estate, prices remain elevated. The Fed said farmland prices are elevated compared to rents and income, while strong home sales are pushing single-family prices. Part of that is fed, of course, by low-interest rates. Still, the Fed pointed to some worrying signs in for-sale housing. Specifically, it noted that “the unusually large number of mortgage loans in forbearance programs and the uncertainty around their ultimate repayment” remain downside risks to the sector. 

Of note to the CRE industry, the Fed pointed that banks continue to be well-capitalized. While hedge fund leverage is somewhat above their historical averages, the Fed notes that data available may not capture important risks from hedge funds or other leveraged funds.

The Fed sees several potential threats to valuations across the board, including falling investor risk appetite, difficulty containing the virus or a stalling recovery. In particular, it pointed to the energy, travel, and hospitality segments being particularly sensitive to pandemic-related developments.

A longer-term risk will be inflation. 

A recent analysis from S&P Global Market Intelligence notes that rising inflation could upset the bond and equity markets and negatively impact consumer spending.  The Fed tends to prefer measuring inflation by the core personal consumption expenditure price index, which hit 1.8% in March 2021, up from 1.4% in February. S&P Global analysts noted that earlier this month, Goldman Sachs economists predicted core PCE to push higher than 2.4% in April, the biggest year-over-year increase since February 2007. 

While “the Federal Reserve is betting heavily that the stay at these heights will be brief,” the S&P Global report notes, “if this substantial jump is not temporary, or ‘transitory’ as Fed Chairman Jerome Powell has frequently said, the consequences could be dire—potentially forcing the Fed to spend $120 billion in monthly bond purchases and to kick up interest rates as well.