Yellen Eyes Commercial Real-Estate Froth as Fed Weighs ’17 RisksBy
Property prices have doubled, leading to repeated Fed warnings
The boom creates anxiety even as supervision is main defense
A decade after the U.S. housing market collapsed, Federal Reserve officials are watching rising apartment towers as the next potential asset-price bubble, which could add to the debate about the pace of interest-rate hikes this year.
Fed Chair Janet Yellen cited commercial real estate prices as “high” in a speech at Stanford University on Jan. 19. That message has been echoed by Governor Jerome Powell, who warned “low rates may lead to a reach for yield,” as well as Boston Fed President Eric Rosengren, who cited luxury housing in his city.
While single-family housing prices have had a gradual recovery from the mortgage bust, commercial real estate is showing signs of being overheated in markets such as New York, San Francisco and Boston. Fed officials have mostly said they plan to address potential asset price bubbles with financial supervision, rather than by raising interest rates at a faster pace than they currently expect. But such hot-spots are testing their patience.
“It’s an important sector and so has to be on the radar screen,” said Jonathan Wright, an economics professor at Johns Hopkins University in Baltimore and a former Fed economist. “At least a couple of bank presidents would see it as a substantive argument for tighter policy. But I don’t see any indication that the center of the committee is inclined to adopt a faster pace of tightening.”
The Federal Open Market Committee on Wednesday reiterated plans to raise rates gradually, and no one dissented from a decision to leave the federal funds rate target range at 0.5 percent to 0.75 percent. Officials have penciled in three quarter-point rate hikes this year, according to the median quarterly estimate submitted by officials in December. Investors see the central bank taking its time, with a roughly 70 percent probability of a quarter-point hike by the June FOMC meeting.
The Fed targets maximum employment and 2 percent inflation, but is also concerned about ensuring financial stability and not repeating the mistakes of the last crisis, which originated in an overheated residential property market.
“I would describe financial stability risks at this point as being moderate -- so not elevated, not zero, but moderate,” Yellen said Jan. 19.
The Moody’s/RCA Commercial Property Prices Indices, which cover apartment, retail, office and industrial sectors, dropped 40 percent from the start of the last recession in 2007 to the end of 2009. They’ve since more than doubled and now stand 23 percent above the pre-crisis peak.
The Fed’s Beige Book of anecdotal reports, while noting healthy markets mostly, cited some worries including that New York City’s rental market has “weakened noticeably” and “rents of larger units have declined.”
“I continue to be concerned about the commercial real estate market,” Rosengren said in response to questions on Jan. 9 in Hartford, Connecticut. “If you look at prices of commercial real estate, particularly multifamily properties, they have been going up very rapidly in many parts of the country.”
All around Boston luxury apartment or condos have sprung up, he said. “They are all very expensive properties,” he said. “It varies depending where you are in the country, but I think it is certainly something we should be watching.”
The Fed’s concern has been building for a while. In September, Yellen pointed to Rosengren as a point person monitoring of the market.
“Of course, we are worried that bubbles could form in the economy,” she said at a press conference. While it’s difficult to determine a bubble in real time, “We are monitoring these measures of valuation and commercial real estate valuations are high.”
In December 2015, the Fed along with two other bank regulators, the Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency, warned banks to be “prudent” in managing risks in commercial real estate lending.
That caution has done little to stop the momentum in the market, and an adjustment could be in store in 2017.
The delinquency rate for commercial mortgages that have been packaged into bonds is forecast to climb by as much as 2.4 percentage points to 5.75 percent in 2017, reversing several years of declines, as property owners struggle with maturing loans, according to Fitch Ratings.
Exactly how the Fed would deal with that is a question mark.
Banks with high levels of lending concentrated in commercial real estate face “increased regulatory and investor scrutiny,” bank analyst Laurie Hunsicker of Compass Point Research & Trading said in a Jan. 12 report. That is likely to slow their lending growth in the sector and be a drag on earnings, she said.
For all the stepped-up concern, bank supervision is in a period of transition. U.S. President Donald Trump can appoint a Fed vice chairman for supervision, a role currently performed by Governor Daniel Tarullo, who has led the Fed’s push for stricter standards.
Yellen and other officials say supervision should be the first line of defense for preventing bubbles, while leaving open the possibility of using monetary policy, because it gets into all the cracks in financial markets that may be missed by regulation.
“CRE prices have objectively gone up, and even anecdotal reports suggest some froth in that market,” said Roberto Perli, a partner at Cornerstone Macro LLC in Washington and a former senior Fed economist. Yet the repeated warnings may not have much of a policy signal. “Most people at the Fed still think the funds rate is not the appropriate tool to address potential financial instability issues,” he said.