Low Transaction Numbers And Rising Valuations Present Dangerous Combo, Fed Warns

Confidence in the economy is soaring in multiple sectors of high-powered finance, but something concerning might be happening under the hood.

Low transaction volumes in commercial real estate could be masking valuation declines, the Federal Reserve Board of Governors warned in its semiannual Financial Stability report released on Thursday. As investors of nearly all stripes have increased their leverage levels and appetite for risk, commercial real estate and the economy at large are at elevated risk for a sharp drop in value in the case of a negative economic event.

What transactions have been conducted in the past few months have reflected an increase in valuations and narrowing cap rates. Real price growth in commercial real estate increased by 7.5% from Q4 in 2019 to the same period in 2020, the Fed found — far above the 2.8% average annual price growth from 1997 to 2020.

Yet other metrics associated with property valuations remain headed in the wrong direction. Commercial rents in most sectors have continued to decline while vacancy rates have continued to increase, REIT indexes remain valued below pre-pandemic levels, and the rate of delinquency in commercial mortgage-backed securities is still elevated, the Fed found.

Meanwhile, trillions of dollars in capital have flowed into private equity funds and similarly yield-dependent investment vehicles. To the extent that such funds have targeted commercial real estate in the wake of the coronavirus pandemic's outbreak, they have sought distressed assets to find that yield — and largely come up empty.

Should the economic recovery wobble, which the most recent jobs report underscored as a strong possibility, or a renewed wave of the coronavirus force the imposition of shutdown measures again, investors pulling money out of funds pose a risk substantial enough to warrant "structural fixes," the Fed report recommended.

Lael Brainard, a member of the Federal Reserve's board of governors, in a statement released with the report, used Archegos Capital Management's margin call fiasco earlier in the year to underline the risk present in financial markets as currently constructed.

"It highlights the potential for nonbank financial institutions such as hedge funds and other leveraged investors to generate large losses in the financial system," Brainard wrote. "The Archegos event illustrates the limited visibility into hedge fund exposures and serves as a reminder that available measures of hedge fund leverage may not be capturing important risks."