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The Fed’s Financial Stability Report: CRE a Bright Spot

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The Federal Reserve’s biannual November 2020 Financial Stability Report provides a mixed review of what’s ahead for the U.S. economy and commercial real estate. While the impact of the COVID-19 pandemic was mitigated by actions taken by the Federal Reserve and Congress, it remains to be seen what further policy and economic support may be needed. The positive news about the effectiveness and coming availability of a vaccine against the virus lifted markets and spirits, but the counterpoint of rising cases nationwide leaves doubt about the short and long-term outlook for the economy.

The Federal Reserve’s report, which evaluates numerous factors that impact the health of the U.S. economy, concluded that “the outlook for the pandemic and economic activity is uncertain” because of the risks associated with the virus and its effects on the U.S. and global economies.

Commercial real estate outlook

The Fed report found that while asset prices have generally increased since their last Financial Stability Report in May, they “remain vulnerable to significant declines, should investor risk sentiment fall or the economic recovery weaken.”

Commercial real estate property values have started to fall, according to the report, but they remain elevated relative to income. The report acknowledges that low transaction volumes, particularly for distressed properties, make it particularly difficult to analyze commercial property valuations.

“Since the May Financial Stability Report, CRE prices have declined moderately,” according to the Fed report. “However, capitalization rates, which measure annual income relative to prices for recently transacted commercial properties, have remained near historically low levels, suggesting elevated valuation pressures may still exist.”

Some segments of the economy, such as the energy, travel and hospitality industries, are particularly vulnerable if the pandemic continues to spread in 2021, according to the report. Retail, office and lodging properties are the most vulnerable segments of commercial real estate if the economic recovery slows further or the promise of the vaccine or other virus mitigation measures fail.

The Fed study reviewed non-Fed sources of data to evaluate the commercial real estate market and found that vacancy rates are higher and rent growth has slowed or declined for many properties. REITs that invest in lodging or retail properties are priced below their pre-pandemic levels, but those that invest in industrial properties have recovered, the report found.

Tighter standards for CRE lending

Delinquency rates on commercial mortgage-backed securities, which the Fed report said normally contain riskier loans, have spiked since the Covid-19 pandemic  began. Unsurprisingly, given higher delinquency rates and the economic devastation from the virus, the July Senior Loan Officer Opinion Survey on Bank Lending Practices by the Federal Reserve found that a major percentage of banks reported weaker demand for CRE loans. In addition, the banks reported having tighter CRE lending standards during the second quarter of 2020. However, approximately 70% of banks reported tightening lending standards during that quarter, well below the peak of tightened standards of approximately 90% of banks seen in 2008.

Moderate but uneven recovery forecasted

While most forecasters anticipate a moderate economic recovery in 2021, there is more uncertainty than usual among forecasters, according to the Fed report.

“The sharp slowdown in economic activity has disproportionately affected some businesses and households, and a further weakening in the balance sheets of those that are especially vulnerable could affect the financial system,” the Fed said in its report.

For commercial real estate, the Fed wrote, “investor risk appetite and asset prices have increased in recent months but could suffer significant declines should the pandemic take an unexpected course or the economic recovery prove less sustainable.”

In other words, the Fed and CRE investors will need to continue to follow the unpredictable path of the COVID-19 pandemic, the hope for a vaccine and its impact on the economy.

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