There's no doubt that COVID-19 devastated the CRE segment in 2020. Thankfully, the market returned to life in 2021 and even set a record with sales of $809 billion.
But the advent of uncontrolled inflation and growing interest rates may signal the party is over.
As a result, many CRE investors wonder if they should buy, sell, or keep their properties.
The best next step depends on several factors, but one thing is for sure: Commercial real estate (CRE) investors need to be sensitive to economic cycles to protect their portfolios.
This blog summarizes insights from leasing experts and recent CRE market studies to help you make an informed decision in a post-COVID-19 era.
Commercial real estate has, in the past, been an excellent investment to protect against inflation.
That's because owners of CRE properties with short-term leases (like apartments and self-storage units) can quickly raise rents to keep pace with inflation as measured by the Consumer Price Index (CPI).
This is a massive advantage because the CPI reached 8.6% in March and April—the highest it has ever been in the last 40 years.
The US is almost certainly headed toward a recession. Historically, sharp increases in inflation have almost always been followed by a recession over the past seven decades.
All signs point to this. For example, the Producer Index rose to .08% in May and culminated in a 10.8% annual increase.
Likely, these rising costs will be passed on to consumers through higher prices, further pushing the CPI. What's more, gas and diesel prices have reached astronomical levels.
Given that six of the last seven recessions were preceded by sudden increases in energy costs—and with the Commerce Department recently reporting an unexpected decline in retail sales for May—it seems another recession is inevitable.
As you CRE investors know, the general performance of property investments is significantly influenced by GDP growth; they tend to rise and fall together.
When the economy is strong, the demand for commercial property generally increases.
However, commercial rents typically fall when the economy stumbles due to decreased business investment and consumer spending.
The increasingly aggressive monetary policy is expected to result in higher long-term interest rates, potentially triggering a recession and more stringent commercial lending standards.
When interest rates rise, and lending becomes prohibitive, many investors pull back, ultimately causing CRE property values to fall.
During the pandemic, investors favored businesses deemed essential (like grocery stores and pharmacy chains) and were resistant to the effects of lockdowns.
However, landlords will lose money every year with leases that keep their rents flat for ten and sometimes even 15 years.
This is also true for big-box retail and office building owners with long-term leases that are not indexed to CPI.
If you're an investor who owns such assets and is contemplating a sale, consider holding and waiting for the economy to recover.
The decline-and-recovery cycle often takes a decade or more. So, in theory, CRE property owners under 50 can afford to wait for the next upcycle if the market sees a significant correction.
For young CRE investors, this may be an excellent opportunity to buy. While rates are being kept high to fight inflation, they remain historically low.
Those who purchase an income property and lock in a fixed rate at 5.5% to 5.6% will come out on top, as it is unlikely that they will ever see rates this low again.
It's important to remember that real estate differs from other investments like stocks, bonds, and cryptocurrency because its value never drops to zero.
In fact, for the past 25 years, commercial real estate has increased more steadily than the S&P 500 Index, with annualized returns of 10.3% and 9.6%, respectively.
Many experts agree that after a 12-year bull market, commercial real estate values have reached a cyclical peak.
However, some economists have also expressed concerns that banks and non-bank lenders (such as hedge funds) may be over-leveraged in a rising interest rate environment.
There is anecdotal evidence that large CRE portfolio owners, knowing cash is king, are choosing to improve liquidity via planned dispositions at apex price.
In addition, several "distressed" real estate funds are accumulating billions of dollars in a trend that experts say foreshadows an impending market correction.
As a result, banks will have to sell their debt at steep discounts to maintain FDIC liquidity standards, which investors anticipate will significantly increase real estate loan defaults.
What about smaller CRE investors and owner-users?
Now may be time to sell if your property is a medical office building or an industrial unit.
For example, if you're a physician over 60 years of age and you are planning to sell your medical office building to boost your retirement fund, now is a good time for a sale-leaseback.Medical offices are always in demand because they don't falter during difficult economic times.
The population of Americans over 65 is projected to double by 2040, so medical real estate fundamentals are highly secure.
Moreover, this category remains recession-resistant—a solid haven for capital at times when other commercial real estate sectors may be struggling, as demonstrated during both the Great Recession of 2008 and the COVID-19 pandemic.
Sale-leasebacks may also make sense for industrial real estate and related asset types. Now may be an excellent time to convert that illiquid asset into cash.
The pandemic has had different effects on different types of CRE assets. The hardest-hit industries were regional malls, hotels, and student housing.
However, storage facilities, industrial buildings, and data centers have weathered the storm well.
Looking beyond traditional economic approaches is essential in the future when making CRE investment decisions.
This is why leading real estate companies look to futurists, technologists, psychologists, and sociologists for answers.
For example, with fears of another pandemic, will employees demand more significant and private workspaces?
Will people be so afraid of contracting a virus from riding in elevators that they'll avoid living in condominiums?
Although there is still some uncertainty, employing various creative people and applying new approaches—such as deep design interviews—may provide CRE investors with fresh, more predictive insights.
Industry experts are already seeing behavioral changes that may persist even after the health crisis. So for CRE investors, it's crucial to think about how to change and adapt to these shifts.
Even before the pandemic, consumers were already shopping less at physical stores. This acceleration may continue long after the crisis is over—especially as many brands that were already struggling go bankrupt or are forced to reduce their brick-and-mortar locations.
In addition, there is early evidence from China suggesting that the pandemic-induced shift to e-commerce may be here to stay.
Within specific product categories where supermarkets or mainstream retailers compete with online retailers, there have been significant transfers of market share to online players.
The extent and scope of the economic impact on the real estate industry are unknown, just as the scale of human devastation caused by the epidemic is yet to be determined.
However, behavioral changes that may render traditional CRE models obsolete appear imminent.
Given the potential for significant shifts, CRE investors will be well-advised to act immediately to thrive in a future that's considerably different from what we're used to.
