Image Alt Text: How could a recession affect commercial real estate
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After the runaway inflation that affected the United States economy during most of 2022, many commercial real estate (CRE) investors and business owners are wondering if a recession will follow in 2023.
Before we look at the possible effects of a recession on CRE, it’s important to understand exactly what a recession is.
A recession is defined as a slowdown in economic activity across the board, from business lending to consumer shopping. Unemployment tends to rise during a recession.
Most economists define a recession as a minimum of six months of negative Gross Domestic Product (GDP) growth rates.
Factors That Create a Recession
Generally, four factors contribute to creating a recession. They’re often seen after inflation has affected an economy for several months.
- A decline in the stock market. This may contribute to a recessionary environment by reducing investors’ wealth. This may slow down spending and investments.
- Reduced lending. When banks are reluctant to lend money because of a perceived increase in risk, it may contribute to reduced growth.
- Increased business costs. Few businesses are immune from inflation’s effect. Higher prices for inventory force business owners to increase prices. In turn, this causes consumers to limit their purchases.
- Less consumer spending. Inflation causes a decrease in discretionary spending (and an increase in the use of revolving credit). This is why sales of non-essentials may suffer more than essentials.
Considering these factors, it’s inevitable that investors and business owners will be concerned about a recession’s effect on their CRE holdings.
How Is Commercial Real Estate Typically Affected During a Recession?
Investors and business owners with a single type of CRE (industrial, office, retail, or multifamily) will have different considerations if our economy slides into a recession.
Let’s look at each type of commercial real estate and consider how it would fare.
We’ll also consider ways business owners and investors can minimize losses and hedge their portfolios.
#1 – Multifamily Properties
Business owners and investors in an apartment building or similar property may have little to worry about if the economy changes gears. Here’s why.
During the past years, prices of residential properties have skyrocketed. Research has found that the average single-family home is over 43% more expensive than it was in 2019.
Since so many potential homeowners have been priced out of the market, more are relying on rental properties.
Even inflation tends to cause less harm to multifamily property investors. Here’s why: in addition to driving rent rates higher, inflation has challenged builders who are facing rising prices for building materials, reducing new home inventory.
Lastly, research has found that multifamily properties outperformed other types of CRE properties during the 2001 and 2007-2009 recessions.
#2 – Industrial Properties
Since many of these are used for the storage and distribution of consumer and business goods, owners may feel the effects of reduced consumer spending if a recession arrives. This is because inventories would be “managed down,” decreasing industrial space demand.
However, other factors may preserve equity and high tenant rates, including these:
- Supply chain and demand gaps still exist. Until developers can generate enough supply to catch up, industrial CRE demand will continue to be high.
- Consumers will keep consuming. While spending generally falls during a recession, essential household items will see little slowdown in demand.
- Some major U.S. companies are moving production home since many offshoring benefits have disappeared.
The Inflation Reduction Act has also incentivized sustainable manufacturing. When domestic manufacturing grows, so does the need for industrial real estate.
#3 – Retail Properties
While some retail managers may need to adhere to new or improved strategies to keep sales at an acceptable level, there are still options for business owners and investors.
Retail categories that supply essentials are less affected by economic downturns. These include:
- Grocery stores;
- Medical and health-related products; and
- Discounted merchandise and “dollar stores.”
Investors shopping for retail CRE may want to consider properties already home to one or more of these retailers.
Business owners of retail properties selling non-essentials may want to consider these strategies:
- Focus on collecting customer feedback that explains why consumers are shopping during a recession and which products best address their needs.
- Replace mid-tier merchandise with luxury and/or value-priced merchandise.
Consumers buying high-end items are in an income bracket largely unaffected by inflation. Personal luxury sales increased during 2022. Discount chains such as T J Maxx actually saw sales rise 3% during the 3Q of 2022.
#4 – Office Properties
A recession could present an additional challenge to office properties that are already seeing increased risk. Many are still evolving post-quarantine as employers decide if staff will work remotely, within an office, or go “hybrid.”
Class A office buildings generally continue to perform during all but the longest recessions, especially in growing metro areas. However, some employers may look to Class B properties as an opportunity to save, especially those forced to lay off staff.
To counter this possible migration, owners may want to renovate a property to suit its potential occupants.
What Happens to CRE Property Values When a Recession Hits?
Since every recent recession resulted from different factors, it’s difficult to predict how CRE property values may be affected during a recession.
- During the 2008 to 2009 Great Recession, commercial property values fell over 25%.
- However, during the 2001 recession, CRE values were largely unaffected. This was because the failure of business websites was the main trigger.
- The two-month 2020 COVID recession had little effect on commercial property prices. This was one of the rare recessions not preceded by inflation.
While many real estate pundits have proclaimed that commercial real estate is “recession-proof”, this isn’t always true. Potential investors should carry out the same due diligence as other types of investments.
Preservation of liquidity is essential when preparing for a possible recession, as it helps minimize the need for credit with possibly high rates.
Commercial real estate value depends as much on location as on any other property type. For example, office asking rates in cities with decreasing populations, such as San Francisco and Chicago, are considerably lower than asking rates in cities that incentivize businesses to relocate.