The commercial real estate (CRE) sector has largely recovered after the shock brought about by the COVID-19 pandemic. The surprisingly robust employment market has kept demand high, and rents and occupancy are increasing slower than last year, although still rapidly enough to suggest that order is sustainable.
Although property fundamentals are strong, investors are still feeling uneasy. They understand that as interest rates rise, so does the likelihood of inflation and recession—all of which will hurt their CRE investments.
Unfortunately, the anxiety is not unfounded. Even though the actual performance of the properties themselves has been exceptional, these external factors are now delaying transactions and hurting asset values.
Analysts agree that from now on, the CRE investment and operating environment will be more exposed to economic factors beyond simple supply and demand. Investors must therefore examine the influence of these new trends on property cash flows and investment returns, as well as how they affect market liquidity.
There is also concern that the plentiful capital accessible for commercial real estate for more than a decade may dry up when other investment alternatives provide higher risk-adjusted returns. The coming months will slowly unveil these dynamics.
In this blog, we’ll talk about whether or not CRE, as an inflation hedge, can overcome the impact of higher capital costs. Will a triple punch of high-interest rates, inflation, and a recession dampen the recovery of the CRE market?
The impact of high-interest rates on CRE
A high-interest rate environment is a dangerous threat to the commercial property sector. Both rate indices and credit spreads are widening, so if you have debts maturing soon, you will need to readjust your deal economics.
Investors are pausing and reconsidering their strategies due to declining yields and the lack of clarity surrounding interest rates at the exit. In addition, lenders are getting increasingly nervous about what will happen to the debt service coverage ratio of debt payments, starting outpacing net operating incomes. Reduced cash flow cushions and the risk of a lower collateral value have made credit capital less readily available, at least in the near term.
On the bright side, many Commercial real estate loans with terms ranging from seven to ten years will mature in an interest rate climate comparable to when the loan originated. But, as usual, the real-world impact varies by property and market.
For the last ten years, interest rates have been low, and a lot of money has been available, widening the spread between interest rates and capitalization rates. This has led many people to believe that interest rates can continue growing without having any influence over cap rates. But this doesn’t seem to be the case. Over the last few months, we have observed cap rates rising in particular markets and property types.
Is this a cause for worry? It depends. As interest rates level out, so will cap rates; it is essential to remember that CRE valuation and performance have always been and will always be cyclical. The impact will depend highly on the varying demand for space in various markets.
The impact of high inflation rates on CRE
As we’ve seen since the beginning of this year, inflation will directly affect property construction and operating costs. Much of this can be attributed to issues within the supply chain, but those disruptions are slowly ending.
That said, certain costs are expected to continue to rise shortly. This includes wages and benefits, given the continuing strength of the employment market and prevalent labour shortages.
In addition, because of political unrest and severe climate in numerous areas, utility costs are expected to stay high. And as climate change rages on, the rates for property insurance will continue to go up.
Real estate as an inflation hedge depends on rental prices growing faster than inflation. This is determined by property type and market, as well as how quickly the landlord can raise rents and change the length of the lease.
The pandemic, investors preferred leases that ensured stability over a long period. These leases are less desirable unless they have built-in provisions for renegotiation at specified intervals.
In theory, owners of CRE assets with short-term leases (including hotels, multifamily, and self-storage buildings) can rake in extra money from an inflationary uptick in rent prices—but only if there’s high demand and limited supply overall.
Therefore, the usefulness of CRE as an inflation hedge is situation-dependent; it only works when favorable market conditions, such as during periods of continued job growth and in-migration.
All this said, it’s worth noting that inflation is generally beneficial for real estate because it results in higher prices for a shorter period. According to Cushman & Wakefield, every 1% rise in inflation is linked to a 1.1 percent boost in overall investment returns in REITs and pension funds.
During periods of high inflation, CRE equity positions have generally been highly leveraged; however, increased rental revenue owing to inflation has boosted equity returns and protected CRE property values.
In other words, the forces currently propelling inflation may also strengthen CRE. Higher labor and supply chain costs restrict new construction, which is good news for existing properties. Because of the current supply and demand, commercial property values will probably stay strong.
Furthermore, the double-hedge effect occurs as interest rates rise, raising financing costs and slowing growth in the construction sector. Therefore, the economic environment is advantageous for the office CRE segment. As a result, investors in this niche can concentrate on incorporating important features and integrated technology to meet the changing demands of customers and young professionals.
There’s more good news. Recent data suggests that commercial and multifamily mortgage delinquencies in all sectors have returned to pre-pandemic levels At the end of last year, the CMBS delinquency rate was 4.02 percent—a decline of 0.84 percentage points from the third quarter. Many analysts believe that falling delinquency rates and rising rents together make CRE the perfect inflation hedge.
The impact of a recession on CRE
Analysts say that a recession shouldn’t have much of an impact on CRE because of two reasons:
(1) strong employment numbers are keeping space demand high, and
(2) there are indicators that the economic downturn won’t last very long.
The current low unemployment rate and the high number of job openings could protect the hospitality and retail sectors from a downturn. This will not change unless a severe recession results in rapid layoffs. Hotels have been posting the highest average occupancy rates since the pandemic, and retail sales are continuing to rise.
But there is more to a recession than just numbers. It’s important to take into consideration human behavior, too. The psychological effects of a recession—particularly the fear of losing one’s job—could discourage consumers from spending.
A continued high inflationary environment may also force households to reduce discretionary spending and save for necessities. The fear of stagflation, defined as persistently high inflation combined with stagnant demand and high unemployment, can worsen the downturn.
A weakening economy will lead to a further downturn in office demand, on top of the already-weakened order resulting from the rise of the working-from-home culture. As you probably already know, the office market has been hard hit recently—particularly Class B and C properties that can’t provide the space design and services tenants now expect.
Liquidity has evaporated from this asset class (except for office-to-multifamily conversions), and many lenders have avoided lending money to office projects since last year. There’s a genuine possibility that office sector distress may be exacerbated by rising costs, falling demand, and higher interest rates.
Stated income commercial loans are a type of financing that allow borrowers to qualify for a loan based on their stated income, rather than providing documentation of their income. These loans can be a good option for self-employed borrowers or those with non-traditional income sources.
CRE has always been one of the most reliable investment options, regardless of the state of the economy. It has always performed well in the past and will continue to do so, especially with rising demand.
To thrive in these choppy waters, it’s essential for CRE investors to keep a close eye on the severity of these three threats—inflation, interest rates, and recession—and how they affect commercial real estate. However, it’s also important to be realistic and pragmatic, building resilience every step by surrounding yourself with reliable CRE financing sources.
Though it’s impossible to tell exactly when today’s inflationary period will eventually end as it has in the past, in the best-case scenario, inflation and interest rates will stabilize by the middle of 2023, and any upcoming recession will be short-lived. But because these threats are exogenous, CRE investors have to learn how to prepare.