Why Is the Fed Singling Out CRE Prices Now?

By Erika Morphy | National

WASHINGTON, DC—The Federal Reserve Bank'sSemiannual Monetary Report to Congress is, at heart, the presentation of what developments the Fed believes are significant to its decision-making about monetary policy and to a larger extent, the US economy.

So in that respect it should not have been that much of a surprise that the Fed singled out rising commercial property prices as one of the metrics it is watching in its latest report released last week. After all, property valuations and the way these loans were packaged and sold were at the heart of 2008's financial meltdown.

But on the other hand it was something of an eye-raiser. Prices have been rising steadily almost since the end of the recession. What is different now?

But first, this is what the Fed said in its report:

Valuation pressures in commercial real estate are rising as commercial property prices continue to increase rapidly, and underwriting standards at banks and in commercial mortgage-backed securities have been loosening.

There are theories, of course. One is that the Fed is clearly going to increase interest rates this year and to prevent another variation of 2013's taper tantrum, is laying its cards on the table now.

Another possibility is that prices did seem to rise particularly fast this year, enough so that the Federal Reserve Bank highlighted it in its report -- a suggestion posed by Andrew McCulloch ofGreen Street Advisors. Also, depending on what index, or indices, the Fed is using, it could be argued that CRE pricing is above the peak of the last cycle, he said.

Indeed, at the start of the month institutional-quality commercial real estate was up 5% this year, according to the Green Street Commercial Property Price Index and has increased by more than 10% over the past twelve months. In addition, values may well continue to move higher, especially as pent-up demand from large institutional investors finds its way into the system, Peter Rothemund, an analyst at Green Street Advisors, said in a prepared statement with the release of the figures.

But, he added, "the double-digit gains of past years are probably behind us."

Perhaps that is the reason that the Fed's statement doesn’t give the sense of undue alarm or concern, Green Street's McCulloch tells GlobeSt.com.

"I don't think the Fed is particularly worried based on the wording in the report," he says.

He also highlights the Fed's statement about loosening underwriting as important. Separate data certainly bears the Fed out on this point. Moody’s Investors Service has cautioned at least twice this year that underwriting is becoming an issue for newly issued CMBS in part due to peaking commercial property prices.

A final, and perhaps the most intriguing, suggestion is that while institutional-quality real estate pricing has been steadily rising, it wasn’t until recently that lower-quality and smaller properties started to accelerate, which according to CoStar's July release of its Commercial Repeat Sale Indices (CCRSI), is what is happening now.

The CCRSI consists of a value-weighted US Composite Index and an equal-weighted US Composite Index. These gained 1.4% and 1.7%, respectively, in the month of May 2015. The value-weighted U.S. Composite Index advanced 12.2% in the trailing 12 months ended May 2015, and now stands 12% above its prior peak.

The equal-weighted US Composite Index began its recovery later in the cycle, CoStar reports, but has increased at a faster rate of 14.1% in the trailing 12 months ended May 2015 as smaller commercial properties continued to gain favor with investors.

There were other signs of peak record activity in CoStar's report.

For the 12 months ended as of the second quarter of 2015, net absorption across office, retail, and industrial asset classes totaled 575.5 million square feet, a 39.3% increase over the 12-month period ended as of the second quarter of 2014, and the highest annual total on record since 2008.

Also, CoStar reports that commercial real estate trading activity in the first five months of 2015 was well above last year’s total.

"In fact, the US composite pair volume of $115.7 billion for the 12 months ended May 2015 was the highest on record for the CCRSI, indicating that investment flows into real estate remain strong."

The Fed surely isn't the only one taking note of all this: value-conscious buyers will start to retreat to the sidelines if they haven't already. Probably, though, they won't stay there for long. Federal Reserve Chair Janet Yellen all but sent a telegram to Congress indicating that rates are going to rise this year.

And when they do -- property valuations should moderate.

For an irreverent take on the macroeconomic environment, check out GlobeSt.com's Chief Economist authored by Dr. Sam Chandan.