According to economic forecasters, the United States is at risk of sliding into a recession next year as the Federal Reserve pushes interest rates higher to tackle stubborn inflation. Just how far the economy slumps depends on how fast inflation falls back to the Fed’s targeted range of two percent.
Recessions don’t bode well for commercial real estate. During recessions, companies often cut costs by laying off workers, meaning they need less office space to rent. Consumers buy less so brick-and-mortar retail outlets suffer. A weak job market translates into an unwillingness among renters to pay premiums for apartments. Rising interest rates also hurt landlords because they tend to push down property values. Still, there is good news for building owners and managers bracing for tough economic times. The coming recession, if there is one, is not expected to be long lasting. Plus, relief may come quickly in the form of central banks pivoting and slashing interest rates, therefore lowering the cost of debt. If the anticipated downturn is moderate and short-lived, the labor market would likely feel much less pain than during previous recessions with unemployment expected to climb from 3.7% today to somewhere between 4% and 5%. This would be welcome news to stakeholders in office buildings and hotels serving business travelers, as both are highly dependent on the health of the job market.
Predicting the future is inherently tricky, and perhaps a fool’s gambit. That said, a potential recession next year doesn’t necessarily mean gloom and doom for commercial real estate. There are bright spots that may shine in a slowdown.
Economic headwinds may provide benefits to owners and operators of multifamily real estate. That’s because a large percentage of would-be single-family homeowners are opting to rent, driving up demand for multifamily properties. With the cost of an average single-family home up 44 percent in the past three years, the multifamily apartment sector is still in an expansionary phase and well positioned to weather a recession. Multifamily housing displays striking recession-resistant features, one of which is the intrinsic human need for affordable housing options regardless of bull or bear market status. Housing is a fundamental human requirement and, when faced with the prospect of a downturn, many risk-averse individuals choose to continue renting rather than explore the economic stresses of homeownership. It is worthwhile noting that in previous recessions, multifamily cumulative rent experienced only a 7.9% decline, contrasted to 17% in industrial/office rent and approximately 14% in retail.
The U.S. retail sector has emerged relatively well from its COVID-induced bottom. Neighborhood retail centers in densely populated areas are performing and likely will continue to prosper in a recession. That’s not the case for all retail, though. B and C class malls are already limping, and a recession would put them through a very difficult economic period, potentially leaving many malls vacant. Vacant malls contribute to urban decay, declining property values, and lower tax revenues. Because of these adverse effects, it is important that vacant retail stores are repurposed for other uses. According to a 2020 study by the National Association of Realtors (NAR), major re-uses for vacant malls were warehouses, and multi-family/residential buildings. The NAR also reported that vacant malls were repurposed as delivery/distribution centers, health care/hospitals, and community colleges. Other uses were as churches, offices, sports/fitness centers, call centers, data centers, self-storage spaces, flex spaces, or even as a cricket stadium or a police precinct. The NAR concluded its study by underscoring the importance of public financial support to spur development of vacant malls. Federal, state and local government must lead in the repurposing effort through infrastructure, financial incentives, and streamlining the process for investors.
Class A office buildings, which offer a breadth of amenities, are continuing to perform well with limited vacancies, benefiting from the recent Return-to-Office movement. But in a coming recession, employers may look to B and C office properties as an opportunity to save money, making these properties more attractive. Older office buildings may also offer the opportunity to be repurposed into residences to keep up with demand for multifamily housing. As we mentioned earlier, unemployment is doubtful to rise significantly if a recession is in the cards next year. The office sector, therefore, is unlikely to face the risk of tenants cutting headcount and dramatically reducing the demand for space. Office demand is anticipated to continue to be strong in many Sunbelt cities, while vacancy rates in cities like New York, San Francisco and Chicago may remain stubbornly high.
Hotel executives report that the tailwinds of today will help them ride out the potential headwinds of tomorrow. This is largely thanks to pent-up demand for domestic and international leisure travel, as well as a modest revival for in-person business meetings and events. Rising demand, coupled with historically low industry supply growth, should continue to drive strong pricing power for hotels -- recession or not. One segment set to shine is extended-stay hotels. Extented stays have significantly outperformed the rest of the hotel industry even during the deepest depths of the COVID-19 downturn in 2020, and they are similarly poised in the face of a recession.
While the likelihood of a global recession is not certain, commercial real estate professionals need to take the long view. We are currently in a down economic cycle that may — or may not — cascade into a full-blown recession. No matter the outcome, several leading commercial real estate experts cite strong economic fundamentals and say we’re not in the same dangerous waters as in 2000 or 2008.
It is important to remember that every economic downturn in history has been followed by a bull market for real estate. And that is why renovating and repairing properties now makes good sense. Let's take the example of a large apartment building. Any upgrades to existing units today creates a ‘spread’ in rents, as the landlord can charge more for the newly renovated units compared to the non-renovated units. Increased rents on these units will incrementally pay for the renovations in a shorter amount of time, while leaving the owner with a more highly valued property. This strategy also leads to more choices to offer potential tenants. The newly renovated apartments can be targeted at tenants less impacted by a recession, while the unrenovated, less expensive units can be leased to more cost-sensitive renters. This slow rollout strategy can be equally applied to an office building or retail property.
If you’d like to discuss a renovation or build-out, contact the Cicero Construction team. With more than 50 years of experience in both boom and gloom economies, we are an expert source for you to turn to during uncertain times.