The commercial real estate sector has been under intense pressure globally
as interest rates have risen over the past couple of years. In the United
States, with the largest commercial property market in the world, prices
have tumbled by 11 percent since the Federal Reserve started raising
interest rates in March 2022, erasing the gains of the preceding two years.
Higher borrowing costs tend to
dampen commercial property prices directly by making investments in the sector more expensive, but also
indirectly by slowing economic activity and reducing the demand for such
properties. Nevertheless, the sharp decline in prices during the current US
monetary policy tightening cycle is striking. As the
Chart of the Week
shows, contrary to the current policy cycle, commercial property prices
remained generally stable or saw milder losses during past Fed rate hikes.
Some of the earlier rate hikes, though, such as in 2004-06, were
subsequently followed by a recession during which commercial property prices
recorded notable declines as demand fell.
Part of this divergence in price behavior between the recent and past
monetary policy tightening cycles may be attributed to the steep pace of
monetary policy tightening this time around, a factor that has contributed
to the sharp increase in mortgage rates and commercial mortgage-backed
securities spreads. It has also notably slowed private equity
fundraising—an important source of financing for the sector in recent years,
as noted in our recent
Global Financial Stability Report.
Notwithstanding recent declines in US Treasury yields, higher financing
costs since the beginning of the tightening cycle and tumbling property
prices have resulted in rising losses on commercial real estate loans.
Stricter lending standards by US banks have further restricted funding
availability. For example, about two-thirds of US banks recently reported a
tightening in lending standards for commercial construction and land
development loans, up from less than 5 percent early last year.
The effects of tightening financial conditions on commercial property
prices over the past two years have been compounded by
trends catalyzed by the pandemic, such as teleworking and e-commerce, that have led to a
drastically lower demand for office and retail buildings and pushed vacancy
rates higher. Indeed, prices have slumped in these segments, and
delinquency rates on loans backed by these properties have risen in this
cycle of monetary policy tightening.
These challenges are particularly daunting as high volumes of refinancing
are coming due. According to the
Mortgage Bankers Association, an estimated $1.2 trillion of commercial real estate debt in the United
States is maturing in the next two years. Around 25 percent of that is
loans to the office and retail segments, most of which is held by banks and
commercial mortgage-backed securities.
Prospects for the sector remain challenging, even as Fed officials signal interest rate cuts this year and investors grow more optimistic about a soft landing for the economy. Financial intermediaries and investors with a significant exposure to commercial real estate face heightened asset quality risks. Smaller and regional US banks are particularly vulnerable as they are almost five times more exposed to the sector than larger banks. The risks posed by the commercial property sector are also relevant for other regions, for example, in Europe, as many of the same factors are at play as in the US.
Financial supervisors must continue to be vigilant. Rising delinquencies and defaults in the sector could restrict lending and trigger a vicious cycle of tighter funding conditions, falling commercial property prices, and losses for financial intermediaries with adverse spillovers to the rest of the economy. Ongoing monitoring and management of risks related to the sector will be important to mitigate potential risks to macro-financial stability.
