Fed Warns of Trouble in Commercial Real Estate Market

The Federal Reserve expressed concern over the commercial real estate market in its latest Financial Stability Report and revealed closer monitoring by officials.

More than three years since the beginning of the COVID-19 pandemic, office buildings remain empty as many office jobs shifted to remote work. That shift “could lead to a correction in the values of office buildings and downtown retail properties that largely depend on office workers,” the Fed said in its report.

“Commercial Office is on the edge of falling off the cliff, and there's no doubt it's going to fall,” said real estate investor Steven Pesavento, President of VonFinch Capital and host of “The Investor Mindset” podcast.

"Buyers and sellers are out of alignment because of the uncertainty from the Fed,” Pesavento said. "Buyers need to assume rates will keep going up, while sellers are expecting last year's prices today — leading to no-deal.”

Rising interest rates over the last year have added additional pressure, as mortgage borrowers may not be able to refinance their loans, the Fed said.

With commercial real estate values remaining “elevated,” the Fed said, “The magnitude of a correction in property values could be sizable and therefore could lead to credit losses.”

As a result, the Fed “has increased monitoring” of the performance of commercial real estate loans and expanded examination procedures for banks with significant commercial real estate exposure.

"High rates, with lower LTV (Loan to Values), is causing buyers to require more equity when buying and driving down returns,” Pesavento said. It creates “a tough market to hit return minimums for investors.”

The Fed warned that loans with high LTV ratios are harder to refinance or modify, and that if commercial real estate values fall, LTV ratios “could rise considerably.”

For investors, Pesavento said the commercial multifamily is still strong, “yet impacted by the same buyer and seller misalignment of pricing expectations.”