Commercial real estate prices again become a major factor in Fed interest-rate thinking

A decade after the U.S. housing market collapsed, Federal Reserve officials are watching rising apartment towers as the next potential asset-price bubble, which could add to the national debate about the pace of interest-rate hikes.

Federal Reserve Chairwoman Janet Yellen cited commercial real estate prices as "high" in a speech on Jan. 19. That message has been echoed by Fed Gov. Jerome Powell, who warned "low rates may lead to a reach for yield," as well as Boston Fed President Eric Rosengren, who cited luxury housing in his city.

While single-family housing prices have made a gradual recovery from the mortgage bust, commercial real estate is showing signs of being overheated in markets such as New York, San Francisco and Boston. Fed officials have mostly said they plan to address potential asset price bubbles with financial supervision, rather than by raising interest rates at a faster pace than they currently expect. But such hot-spots are testing their patience.

"It's an important sector and so has to be on the radar screen," said Jonathan Wright, an economics professor at Johns Hopkins University in Baltimore and a former Fed economist. "At least a couple of bank presidents would see it as a substantive argument for tighter policy. But I don't see any indication that the center of the committee is inclined to adopt a faster pace of tightening."

The Federal Open Market Committee (FOMC) last week reiterated plans to raise rates gradually, and no one dissented from a decision to leave the federal funds rate target range at 0.5 percent to 0.75 percent. Officials have penciled in three quarter-point rate hikes this year, according to the median quarterly estimate submitted by officials in December. Investors see the central bank taking its time, with a roughly 70 percent probability of a quarter-point hike by the June FOMC meeting.

The Fed targets maximum employment and 2 percent inflation, but is also concerned about ensuring financial stability and not repeating the mistakes of the last crisis, which originated in an overheated residential property market.

"I would describe financial stability risks at this point as being moderate — so not elevated, not zero, but moderate," Yellen said Jan. 19.

The Fed's Beige Book of anecdotal reports, while noting healthy markets mostly, cited some worries including that New York City's rental market has "weakened noticeably" and "rents of larger units have declined."

"I continue to be concerned about the commercial real estate market," Rosengren said in response to questions on Jan. 9 in Hartford, Conn. "If you look at prices of commercial real estate, particularly multifamily properties, they have been going up very rapidly in many parts of the country."

All around Boston, luxury apartment or condos have sprung up, he said. "They are all very expensive properties," he said. "It varies depending where you are in the country, but I think it is certainly something we should be watching."

The Fed's concern has been building for a while. In September, Yellen pointed to Rosengren as a point person monitoring of the market.

"Of course, we are worried that bubbles could form in the economy," she said. While it's difficult to determine a bubble in real time, "We are monitoring these measures of valuation and commercial real estate valuations are high."

That caution has done little to stop the momentum, and an adjustment could be in store in 2017.

The delinquency rate for commercial mortgages that have been packaged into bonds is forecast to climb by as much as 2.4 percentage points to 5.75 percent in 2017, reversing several years of declines, as property owners struggle with maturing loans, according to Fitch Ratings.