IMF report on CRE price movements across the Fed’s tightening cycles

In a recent blog post, IMF economists Andrea Deghi, Fabio Natalucci, and Mahvash S. Qureshi analysed the precarious position the commercial real estate (CRE) sector finds itself in despite rising expectations of a soft landing.

CRE prices have fallen sharply by over 11% following the aggressive pace of monetary tightening undertaken by the Federal Reserve over the last twenty-one months.

Although tighter monetary policy would usually be expected to hurt or at least slow commercial real estate prices due to higher borrowing costs, stumbling demand, and weaker economic growth, the above graph shows that this does not appear to have always been the case.

However, the 2022-23 period has been a particularly difficult cycle for the sector.

The authors note that due to the onset of recessions, some of the earlier tightening cycles saw sharper falls in CRE prices in subsequent quarters.

The drop in funding

The scale of the current drop-off is most likely a result of the unprecedented pace of tightening undertaken by monetary authorities, significantly stricter lending restrictions across the banking sector following the onset of the regional banking crisis, as well as the free fall in private equity funding for the space.

As of July 2023, the IMF reported that delinquencies among commercial mortgage-backed securities (CMBS) for the office subsector doubled since 2021 to 4.5% amid losses in CRE loan portfolios.

Outlook

The Global Financial Stability Report - October 2023 (GFSR) of the IMF notes that hotels and offices are responsible for 34% and 25% of maturing CRE loans in 2023, respectively.

With over a trillion dollars worth of CRE debt coming due within the next twenty-four months, the outlook for the sector, and in particular offices, is challenging due to dampened demand, vacancies, and the trends in remote working.

The maturing debt and required refinancing pose a significant asset risk to banks and other financial institutions that have interests in this space.

Despite rising expectations of rate cuts in the United States, the IMF blog notes a key concern,

Thus, the threat to a subset of the US banking system amid increasing defaults remains elevated and could potentially spread to other parts of the economy.

The blog emphasizes that a negative fallout due to defaults and delinquencies could have additional knock-on effects on lending which would squeeze vital sources of liquidity, and drive CRE prices even lower, leading to an escalation of risks for investors and lenders.

In Q2 2023, expected defaults (one year ahead) among real estate investment funds surged from 0.7% in 2021 to 2.5%, while the GSFR projected that the funding gap for the sector is expected to widen significantly across several major economies during 2024.

Market watchers will have to wait to assess how effectively the Fed’s intended lower rate path may ease debt costs in the future.  

As credit quality threatens to continue to deteriorate across the sector, tighter financial conditions are likely to weigh upon refinancing activity, particularly among office properties, which may warrant extending policy measures to contain potential risks.

National Financial Conditions Index (NFCI)

Interestingly, the NFCI published by the Chicago Fed, which is an amalgamation of 105 relevant indicators has persisted in negative territory despite the Fed’s monetary tightening.

In the latest release, the NFCI dipped further to -0.54 as of 12^th January 2024, with the FRED Database noting,