CRE, residential home markets no risk to financial system for now – but weaknesses would be tested in recession, agency reports

Neither the commercial real estate (CRE) nor the residential real estate markets pose a significant risk to the U.S. financial system in the foreseeable future, but growing weaknesses in both will be tested in a recession, according to a blog post published Thursday by the Treasury’s financial research arm.

According to the blog post published by Treasury’s Office of Financial Research (OFR), the CRE market performed well throughout most of last year, but it is now showing weakness. Meanwhile, home prices softened in 2022, in conjunction with the Federal Reserve’s interest rate increases.

“While these markets have been resilient until recently, their strength will be tested if a recession occurs,” the post asserts.

“The CRE market weakened during the latter part of 2022 in response to the Federal Reserve’s interest-rate increases,” the post asserts. “The weakening of the CRE market has further accelerated during early 2023.” The post explains that rising interest rates reduced the present value of properties with fixed cash flows and made the financing of CRE purchases more difficult.

“Given economic conditions and rising interest rates, overall CRE prices are now declining, with a 6.3% decline in the RCA CPPI (Real Capital Analytics, Commercial Property Price Index) index during the three months ending in January 2023,” the post states. “Declining property values will cause loan performance degradation at CRE lenders—especially those that were most aggressive in their lending terms, such as those with high loan-to-value ratios. Most capitalization rates are rising in tandem with interest rates, causing the values of some properties to decline.”

On residential real estate, the post notes that home affordability is now the lowest it has ever been, as home price growth is outpacing wage growth. “Since the pandemic, home prices have risen to record levels,” the post states. “The increased demand for homes led to dramatic increases in mortgage activity in 2020 and 2021.”

The post asserts that the risk to financial stability is related to home values. “Record housing prices resulted in higher monthly payments for new homeowners with mortgage debt during this period.”

A correction in home prices to historic levels, depending on its speed and severity, could pose two risks to U.S. financial stability, the post states: Falling home prices could erode household wealth and dent consumer confidence and spending, and reduced loan-to-value could generate defaults, distressed sales, and loan losses.

But, given the tight housing supply, the post notes that declining home prices are not an immediate concern.

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