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This week, researchers at the International Monetary Fund released their April 2021 Global Financial Stability Report, in which the IMF outlines potential risk scenarios to the global economy caused by spillover economic effects of the covid-19 pandemic through various sectors–including commercial real estate.

In the report, the IMF points to three “key channels” through which declines in commercial real estate prices typically feed through to other parts of the global financial system in a systemically threatening way–and may do so in the wake of covid. First is through the bank solvency channel, or the credit risk to banks from borrower defaults and/or exposure to mortgage-backed securities. This scenario came perilously close to materializing early in the pandemic. In March 2020, the IMF notes, the U.S. commercial mortgage-backed securities market was “severely disrupted” due to stress in funding markets, which reverberated across commercial real estate, forcing the U.S. Federal Reserve to step into the agency commercial MBS market and buy nearly $9.3 billion in securities from Fannie Mae, Freddie Mac, and Ginnie Mae to stabilize the market.

Second is the collateral channel, or the use of commercial real estate as a form of collateral by non-financial firms seeking credit from financial companies, which in conditions of declining real estate prices shrinks investment, borrowing activity, and economic activity (and can also, the IMF notes, feed back through to the bank solvency channel by raising bank loan-to-value ratios, and in turn their risk-weighted assets, and thus their regulatory capital ratio). A small move in this channel can have huge ripple effects. For example, the IMF writes, a decrease of just one-standard deviation in the market value of real estate assets implies a decrease in the ratio of investment to the value of property, plant and equipment by 21 percent.

And finally, the IMF notes, there’s the non-bank financial institutions channel–institutional investment funds, pensions and insurers–which typically hold assets indexed to real estate prices. Declining real estate prices can either inhibit the willingness of these entities to invest in real estate, or to liquidate positions in response to redemption pressures by their own investors. This, in turn, given the historic illiquidity and maturity mismatch of real estate investment funds can intensify price declines. This channel, the IMF observes, can also feed back negatively into the bank solvency channel, due to the reliance on bank financing of many investment funds.

Historically, the IMF says, the commercial real estate sector has been either a “source or amplifier” of macroeconomic shocks: recent examples include not only the Global Financial Crisis of 2007-2009, but also the early 1990’s Swedish housing bubble, the U.S. Savings & Loan crisis in the 1980’s, and the Irish banking crisis of 2008-2011.

Covid: not caused by real estate, but still… 

While the covid-19 pandemic of 2020 was certainly not caused by real estate exposures, the IMF says it still poses risks to financial stability due to the sheer size of sector, and the fragile economic outlook.

Globally, commercial real estate assets totaled 20 percent of GDP (at the end of 2019) across most major advanced and emerging economies, and up to 50 percent or more in some economies (the IMF offers Singapore, Sweden and Switzerland as examples). Banks, they note, are strongly exposed to the sector, with direct lending for commercial real estate accounting for more than 50 percent of total bank lending to non-financial companies as of 2019. In the U.S. alone, more than 165 percent of regulatory capital among smaller banks (i.e., those with assets of less than $100 billion) committed to commercial real estate and construction lending (compared to 50 percent for large banks), pointing to significant risks at the local or regional level that could become systemic at scale.

Prior to covid-19, the IMF notes, median commercial real estate prices rose across many economies, with real prices nearly doubling in the U.S. and Sweden in the post-GFC decade from 2009-2019, driven by a low interest rate environment, which encouraged investors to seek higher investment returns in asset classes like real estate.

While the IMF says that most economies did not enter the pandemic with explicit signs of overvaluation, commercial real estate price misalignments have increased since 2020, with lower median real estate prices met by a similarly large drop in aggregate demand and net income, neither of which has been fully offset by aggressive monetary easing by central banks.

“By and large, these findings suggest that the covid-19 pandemic has resulted in a large shock to commercial real estate market fundamentals, affecting both supply and demand,” the IMF writes. “While some of the factors are conjunctural, related to the recession and the pandemic, others may be reflective of underlying structural changes to come in the commercial real estate market and the economy at large. In this environment, commercial real estate prices may not yet fully reflect these changes, especially in light of the huge uncertainty about the economic outlook, making an assessment of price misalignments more challenging.”

Per the IMF, a permanent increase in the commercial real estate vacancy rate of just 5 percentage points would have an impact twice as large on bank capital (which could, in turn, undermine financial stability). Such a move would also, according to IMF modeling, lead to a median drop in real estate fair values of 15 percent after five years.

What are we supposed to do about this? 

In the near term, the IMF says “policy support to maintain the flow of credit to non-financial companies and stimulate aggregate demand remain essential to facilitate a recovery of the sector and preserve financial stability.” The fund urges that borrower support measures including debt repayment relief, credit guarantees, and direct support be maintain until economic recovery is firmly established.

In the longer-term, tighter targeted measures–such as caps on loan-to-value or debt-service-to-income ratios specific to commercial real estate, or limits on bank exposure to commercial real estate–could be effective. So, too, could borrower-based measures for residential real estate, due to their impact on the broader multifamily commercial real estate segment.

Finally, commercial-real-estate-related systemic risks from non-bank financial institutions demand “urgent” attention, by “broadening the reach of macro prudential tools and granting macro-prudential powers to relevant supervisors as well as by enhancing data collection.”

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