The Looming Threat of Commercial Real Estate Distress and the Fed's Balancing Act

The latest inflation figures in the United States look relatively positive, with a slight decline in annualized inflation rates.

It's important to state that only three items of the CPI components declined in December. Persistent inflationary pressures that threaten to undermine the rate-cut narrative that financial markets have adopted are present below the surface. Investors expect the Federal Reserve to pump the monetary laughing gas machine, anticipating further rate cuts and monetary easing to support multiple expansions.

However, in this wave of fervent optimism, there are dark clouds looming on the horizon: another wave of regional bank troubles added to the burgeoning crisis in the commercial real estate market.

The regional bank crisis was disguised with liquidity, but reality showed that unrealized losses in the banks’ balance sheets rose to all-time highs in the third quarter of 2023. Regional banks remain in deep trouble. According to Moody’s, major US banks are sitting on $650 billion in unrealized losses.

Things are even scarier in the land of real estate. Recent reports paint a grim picture of the commercial real estate landscape, with delinquency rates soaring to alarming levels and non-performing loans rising. The commercial real estate market, once an example of economic strength, stability, and prosperity, now stands on the edge of crisis.

Delinquency rates in commercial real estate have reached a 10-year high, with almost $80 billion worth of property in distress. According to MSCI Real Assets and Fortune, the value of buildings that were bankrupt, under foreclosure by lenders, or in the process of liquidation rose by a net $5.6 billion in the third quarter of 2023. Office properties accounted for 41% of the $79.7 billion total.

According to real estate experts John Smith, the link between corporate bankruptcies and commercial real estate distress is deeply intertwined. One of the central findings of Smith’s research is the interconnected nature of corporate financial health and commercial real estate performance. He notes that corporate bankruptcies can trigger a cascade of financial repercussions, affecting property values, rental income, and investor confidence. This highlights the importance of understanding the broader economic context in assessing the risks and opportunities in the commercial real estate market.

Corporate bankruptcies also exert downward pressure on commercial property values, as distressed companies liquidate assets and reduce their real estate footprint. This can lead to declining rental income and occupancy rates, further exacerbating financial distress for property owners and investors. Smith’s analysis underscores the need for proactive risk management strategies to mitigate the impact of corporate bankruptcies on commercial real estate investments.

So, what does this all mean for the Federal Reserve? The Fed finds itself caught between a rock and a hard place, having to choose between inflation and financial stability. On one hand, persistent inflationary pressures require a monetary contraction and maintaining elevated rates. On the other hand, the risk of a collapsing commercial real estate market threatens to unleash a wave of financial contagion with far-reaching implications for the broader economy.

Remember 2007? Market participants also said that subprime was not a threat because it was a relatively small proportion of all assets in the financial system. This is the same argument that we read today. However, the risk of contagion and the domino effect of corporate bankruptcies and impact on all real estate -not just commercial- is not small.

Will the Federal Reserve choose liquidity and financial stability over reducing inflation? Quite likely. However, the Federal Reserve’s concept of financial stability also means zombification.

One possible course of action for the Federal Reserve is to keep rates and continue with back-door monetary easing as it did in 2023. This may help markets but is only kicking the can forward without the inevitable clean-up of the “everything bubble” created in 2020.

The challenge is that cutting rates may be too little for the accumulated problems of the commercial real estate sector, as it is not just a problem of rates but the evidence of bloated valuations, and rate cuts also risk exacerbating inflationary pressures and fueling other asset bubbles.

Cutting rates will not solve the economy from the problems built through unnecessary stimulus plans and ultra-low rates. Now, inflation erodes the real economy and monetary policy cannot disguise the excessive valuations of the past years for a prolonged period.

The rise of delinquency rates in the commercial real estate market creates a significant challenge for the Federal Reserve, and they will not be able to disguise it with liquidity. The market seems to think this issue is irrelevant. I would be more cautious.