A story of uncertainty and opportunity

Many real estate professionals are feeling a lot of anxiety about the current commercial market, as key market indicators are fluctuating and most predictions for the overall economy include an upcoming recession. In this article, we’ll explore the current state of commercial real estate (CRE) and the various macroeconomic factors in play.

A macroeconomic factor is an influential fiscal, natural or geopolitical event that broadly affects a regional or national economy. Macroeconomic factors include inflation, fiscal policy, employment, national income and international trade.

National economies tend to move through cyclical periods of boom and bust, which government policies attempt to moderate. Macroeconomic factors can be good, bad or somewhere in between. The onset of COVID was a definitively bad factor that’s resulted in massive disruptions in every segment of personal life and global trade. These impacts have brought us to the current state of CRE in the US.

There are five primary property segments in the CRE market: office, retail, industrial, multifamily and hotels. Generally speaking, the current state of the CRE market is good. According to data from CoStar, the values of all five property types as of the third quarter of 2022 are flat or up slightly relative to year-end 2021. However, each property segment has been impacted by different factors and to varying degrees.

Office

COVID kept workers at home, and many of them would like to continue that arrangement. It’s still unclear how this will play out as the threat of COVID fades. Office leases tend to be fairly long. Five-to ten-year terms are normal, with larger tenants often opting for 20-year terms. The length of these leases will provide lucky landlords with a buffer period. It’s likely that older, less ideally located properties will end up being demolished or repurposed as time passes.

Retail

Much of the US retail sector continues to recover from the pandemic’s negative impact as more shoppers have returned to brick-and-mortar retail. Retail vacancy rates are projected to broadly improve over the next two years, which will keep the bulk of this sector in recovery.

COVID accelerated the rapid growth in Internet retail sales, and this is a sector that will continue to grow as consumers have become used to expedited delivery timelines. Class A dominant regional centers will thrive, and grocery or drugstore-anchored strip and neighborhood centers are likely to remain stable. There are a significant number of older, unanchored retail centers that will eventually be redeveloped.

Industrial

This sector has been the standout performer in the CRE market. COVID accelerated Internet sales, and demand for well-located industrial properties boomed. Consumers’ increased expectations about expedited delivery times have driven the market for industrial properties located near dense urban areas.

These last-mile properties are crucial to same-day or next-day shipping. Average overall rates of return for industrial properties are holding in the low 4% range, the lowest of any commercial property type. Another attraction of industrial properties is their triple net lease structure, which shields owners from rising expenses.

Multifamily

The multifamily sector continues to post solid fundamentals, with a significant number of metropolitan areas expected to end 2022 in expansion. While fundamentals may be impacted by the potential for an economic slowdown, the expected decline in single-family home sales could be a temporary boost to apartment occupancy.

One concern for this sector is its ability to sustain the huge increases in rental rates that occurred in 2021. Rental rates are now falling rapidly and could endanger older or over-leveraged properties as inflation pushes up expenses while rents are declining. The majority of apartment lease terms are one year, which means that fluctuations in rental rates will hit the bottom line quickly.

Hotels

With an average length of stay of less than two days, hotel revenues can rise and fall very quickly. As a result of the COVID pandemic, hotel occupancy rates in the US plummeted to 24.3% in April 2020, while average daily rates declined to $73.88. As of October 2022 occupancy rates have rebounded to an average level of 67.2%, and average daily rates have increased to $155.63 (CoStar online data). The leisure segment of the hotel business currently is strong, especially in Sunbelt locations. Business travel is still depressed but expected to pick up in 2023.

Current macroeconomic threats

The odds of the economy falling into recession are climbing, as the Federal Reserve boosts interest rates sharply to rein in inflation that’s lingering at a decades-high rate. As a result, consumer sentiment has plunged and threatens to derail consumer spending that supports two-thirds of the economy.

Despite a few strong rallies, the stock market remains depressed. The Dow Jones Industrial Average is down by 8.7% since January 2022, which tends to put a damper on nonessential consumer spending.

Pandemic-related shortages of material and labor and persistent snags in supply chains have caused prices to vault higher for months. Inflation as measured by the consumer price index (CPI) rose by 9.1% over the year in June, its fastest pace in more than four decades. The rise in the index slowed to 8.5% in July, 8.3% in August and 8.2% in September, mostly due to the falling price of gasoline, suggesting that peak inflation was reached in June. However, core CPI, which excludes food and energy prices, unexpectedly accelerated in August, with broad-based gains across many products and services.

Economic momentum had already flagged in the first half of 2022, which saw two quarters of negative economic growth, often seen as the definition of a recession. With demand continuing to cool, most analysts have downgraded their overall annual growth estimates.

But the labor market is still tight. An average of 562,000 jobs were added every month in 2021, and more than 3.5 million jobs have been added so far in 2022. The unemployment rate in September was 3.5%, ticking slightly higher than the previous five consecutive months, when the unemployment rate was close to its pre-pandemic level. Labor participation also inched higher but is still below pre-pandemic levels, as workers continue to cite COVID fears and a lack of childcare options as reasons to remain on the sidelines.

With 11.2 million job openings recorded on the last day of July, near a record high and representing almost two job vacancies for each unemployed worker, competition for workers is driving wages higher, but inflation is eroding household incomes. Personal income grew by just 0.2% in July, the slowest rate since January, and the personal savings rate held at 5% for the second consecutive month, its lowest rate since August 2009, as households dipped into savings accounts to support their spending.

Other recent data confirm a slowdown in activity. News of hiring freezes and impending layoffs is widespread, suggesting that the labor market will slow in coming days. Business investment is at risk, with factories reporting slower new orders for their products. And with mortgage rates rising to levels not seen in years and housing prices still uncomfortably high, affordability has eroded, leading to a sharp turnaround in what had been a red-hot housing market. Sales of both new and existing homes have fallen in recent months as potential home buyers are being priced out of the market.

Finally, there is the war in Ukraine, which fosters worldwide anxiety regarding energy pricing and availability. Europe is coping with inflation and economic malaise that are more threatening than conditions in the US.

In conclusion, the recurrent theme here is “anxiety” as a result of pressure from factors over which we have no control. Interest rates are high, and current inflation is even higher. Based on the Federal Reserve’s November meeting, there will be further increases in the federal funds rate. Food and gas prices remain elevated. A recession appears likely by 2023. The Federal Reserve is trying for a soft landing but there’s a chance it will fail. The Ukraine conflict could devolve into something much worse.

Commercial property owners will be forced to contend with occupancy and rental rate issues. Borrowing will become more difficult as rising interest rates and more stringent lending standards will reduce available funds.

In the early days of COVID, before vaccines were available, there was a high level of fear as the virus brought with it a risk of severe illness or death. The economic impact of COVID is still with us, as is the anxiety. If enough people believe that inflation will continue and possibly result in a recession, the more likely that scenario is to come to fruition.

At the moment, it’s difficult to accurately predict the state of the CRE market in the coming months and years. Owners and investors need to stay nimble if they’re to avoid the macroeconomic pitfalls of the post-COVID age.

The information provided here is for general guidance only, and does not constitute the provision of tax advice, accounting services, investment advice, legal advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisers.