Fed harps again on growing risk in U.S. commercial real estate

(Reuters) - Federal Reserve officials do not see broad risks developing in U.S. asset markets save for one: commercial real estate.

That concern was evident on Tuesday in the U.S. central bank’s semiannual Monetary Policy Report to Congress, in which commercial property prices were singled out as a “growing concern” even as the Fed described wider risks to financial stability as “moderate.”

“Commercial real estate (CRE) valuations, which have been an area of growing concern over the past year, rose further, with property prices continuing to climb and capitalization rates decreasing to historically low levels,” said the report, which is prepared by Fed staff and delivered to Congress in tandem with Chair Janet Yellen’s twice-yearly testimony to lawmakers.

Yellen appeared before the Senate Banking Committee on Tuesday and will testify to House Financial Services Committee on Wednesday.

While commercial property debt remains modest relative to the overall economy and banks have tightened lending standards, the report said, the rising “valuation pressures may leave some smaller banks vulnerable to a sizable CRE price decline.”

Commercial real estate loans by U.S. banks surpassed their pre-financial crisis levels in September 2015, and at last reading for January stood at a record $1.97 trillion, according to Fed data. Small banks hold nearly two-thirds of that total, some $1.22 trillion.

U.S. commercial property prices have more than doubled from their post-crisis low in mid-2009, according to Green Street Advisors’ Commercial Property Price Index, although 2016’s increase of around 3 percent was the smallest yet in the recovery.

Tuesday’s reference marked the fifth straight MPR to raise a red flag over the sector and was the most pointed to date. Commercial real estate valuations and lending standards also have been a persistent worry of Federal Reserve Bank of Boston President Eric Rosengren.

The Yellen Fed first cited “valuation pressures” for the sector in its February 2015 report, saying then that “prices have risen relative to rents, and underwriting standards in securitizations have weakened somewhat.”

It repeated that concern more forcefully in subsequent reports and a year ago noted banking regulators had taken the precautionary step of issuing a joint statement “reinforcing existing guidance for prudent risk management in that sector.”

Last June’s report was stronger still: “Valuations in the CRE sector appear increasingly vulnerable to negative shocks, as CRE prices have continued to outpace rental income.”

It was at this time that the Fed specifically cited the risk to small banks, a concern it repeated on Tuesday.

Reporting by Dan Burns; Editing by Lisa Shumaker