The Federal Reserve is closely monitoring commercial real estate borrowing as a potential risk to financial stability, according to a new report from the nation’s central bank. Among other factors, the report cites “dramatically reduced” demand for office space which could lead to a correction in values of office buildings and downtown retail properties.
Furthermore, the rise in interest rates over the past year increases risks that CRE mortgage borrowers will not be able to refinance their loans when they reach maturity. With CRE valuations still elevated, any correction in property values could cause significant credit losses by holders of CRE debt.
The report notes that losses on these loans depend on leverage because owners with substantial equity cushions are less likely to default and loans with high loan-to-value ratios are typically harder or impossible to refinance or modify.