The Federal Reserve Acknowledges the $23 trillion elephant in the room.

Commercial Real Estate Poses Financial Stability Risks

The global banking system, particularly in the United States, is facing a significant threat from the commercial real estate sector. This market is estimated to be worth around $23.8 trillion. The Federal Reserve's latest financial stability report highlights this issue as a key concern for policymakers.

Commercial real estate consists of properties that are used for business purposes, such as office buildings, retail centers, and industrial properties. The market is characterized by high valuations and a significant amount of debt, with several trillion dollars in loans and other financial funding requirements attached to it.

The Federal Reserve's report estimates that there is about $3 trillion in commercial real estate debt, of which $2.17 trillion is held by the banking system, with $1.55 trillion held by regional banks. As prices of commercial real estate fall, valuations start to be reduced, and distressed properties become less likely to trade. This situation forces lenders to manage their credit risk and liquidity risk.

There currently is a doughnut effect happening, which refers to the phenomenon where people leave city centers and move to suburban and exurban areas, creating a hollowing out of urban cores. This effect is most pronounced in large cities like New York and San Francisco. The pandemic has accelerated this trend as remote work has become more prevalent, allowing people to choose where they live based on factors other than proximity to their workplace.

The doughnut effect has significant implications in the commercial real estate market. As people move away from city centers, demand for office spaces and downtown retail properties decreases, leading to a potential decline in property values. The Federal Reserve's financial stability report highlights this issue, stating that the exposure of financial institutions to commercial real estate (CRE) is one of the major threats to the US economy. Mortgages backed by office and downtown retail property make up about 1/3 of CRE holdings. With CRE valuations remaining elevated, a correction in property values could be substantial, leading to credit losses for holders of CRE debt.

This decline in the commercial real estate market is leading to systemic issues and liquidity problems for regional banks. This decline in prices has been confirmed by Moody's credit rating agency. This drop could compound the difficulties confronting many banks at a time when they are fighting to retain deposits in the face of a steep rise in interest rates over the past year. The market is valuing commercial real estate loans at a lot less than their previous worth to protect itself from future declines. This situation has led to a $1.5 trillion funding problem for regional banks, as they are not able to access other forms of wholesale funding.

For more analysis on these topics, check out these articles:

1. The "trigger for systemic risk" is being triggered as prices fall for first time in over a decade.

2. They keep pushing rate hikes and short sellers as reason for bank woes when can see it's not.

3. US cities must beware the doughnut effect

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