After a tumultuous 2020 because of the pandemic, the commercial real estate (CRE) industry managed to roar back to life in 2021 with a staggering $809 billion in sales.
But with the arrival of inflation and rising interest rates, is the celebration coming to an end in 2023? Because of this uncertainty, many property investors are faced with making a significant decision: whether to buy, sell, or wait it out.
A look back at history
Private proprietors of commercial real estate have traditionally been provided with a reliable barrier against inflation. This is especially true for owners of buildings, including apartments, self-storage facilities, and manufactured home communities with short-term leases, as they can quickly adjust their rents in line with the Consumer Price Indices (CPI). These benefits are even more prominent now.
After hitting 8% in March and April, the CPI skyrocketed to an unprecedented 8.6% rate come May—one of the highest recorded since 1981.
Back then, just like now, inflation was triggered by an immense gas and oil price surge and an unrestrained Treasury pumping money into the economy.
Paul Volcker (the freshly-appointed Federal Reserve Chairman in 1980) acted upon this issue quickly and restricted currency circulation to a great extent. This led to mortgage rates reaching 20% in December 1981, which promptly brought down inflation levels but resulted in a 10.8% unemployment rate, a 3% fall in GDP, plus two economic recessions.
CRE also suffered a 10-year plummet due to these events, making it clear that although inflation might benefit landlords, it is not so much for the commercial real estate industry.
Trends to watch out for
History has shown that a recession usually follows each significant spike in inflation, and today’s trend appears to be no exception. 98% of US CEOs are expecting an economic contraction within the next year or two. Joblessness is estimated to reach up to 5%. There’s even speculation that recession could be just eight months away.
There’s no question that commercial real estate investors, developers, and stakeholders need to get ready for a difficult period ahead. That said, there are some opportunities as the dust settles.
Success in CRE means staying aware of economic cycles when making investment decisions. Here are some trends to keep in mind when deciding whether to buy, sell, or hold your CRE investments:
Opportunities per asset class
JP Morgan’s 2023 commercial real estate outlook shows plenty of challenges ahead. The future of retail and office space remains to be determined.
In addition to supply chain issues, inflation has increased to a 40-year high, forcing the Federal Reserve to raise interest rates steadily. But despite these challenges, there are some areas with hope in commercial real estate. Multifamily properties remain profitable, while industrial property continues its streak.
- Industrial – The expansion of e-commerce has created an explosive demand for warehouses and industrial space to facilitate the swift delivery of products.
This surge in online retail sales continues to expand rapidly and will undoubtedly drive further innovation—from drones to investments in last-mile distribution complexes.
With e-commerce currently representing less than 20% of retail sales, there is a massive opportunity for expansion. In addition, it is expected to boost the logistics industry for the next decade, particularly for industrial warehouse and distribution properties.
An unprecedented cascade of new warehouses has been built in response to this trend. But ultimately, success in these areas will depend on how well supply and demand mesh together.
That said, industrial real estate may experience more difficulties because of its longer leases, which usually only account for 2% to 3% inflation rates.
- Affordable housing – The demand for inexpensive housing far surpasses the supply available. Regardless of fluctuating markets, CRE investors should cater to this gap by exploring imaginative solutions to create more affordable housing options, such as mixed-income properties, adaptive reuse, modular construction, and unique capital solutions.
- Multifamily properties –The multifamily asset class is currently the most profitable, continuing to break records. At its lowest vacancies in five years (just 4.4% as of the third quarter of 2022), owners and investors alike are reaping the immense benefits offered by this sector despite rising costs. Furthermore, with rents that can be adjusted annually or even monthly depending on changes in the market, multifamily investments remain a highly lucrative endeavor for any savvy investor.
- Retail – In this segment, location and retail category largely dictate the forecast for a given property. People will always require certain items from grocery stores, most notably prescriptions. They’ll also get haircuts or coffee at neighborhood shopping centers in densely populated areas. These types of businesses continue to thrive despite any economic lulls.
After decades of trying to revive B- and C-class malls to generate sales tax, some cities have decided it’s time to change. This does not mean completely losing out on the special sales tax, though, as one can transform these spaces into multi-use properties that feature apartments, restaurants, movie theaters, and even immersive retail experiences.
City-center retail has had difficulty rebounding, primarily because rent levels are often higher than in other areas. This is only exacerbated by fewer people working in downtown offices, causing further growth stagnation.
It’s also important to note that during a downturn in business and consumer spending, retail landlords may find it hard to increase rent prices, which can be detrimental to profits.
Properties like Dollar General and Walgreens tend to hold their value even during crises due to their designation as ‘essential’ businesses. But the issue with these types of investments is that rents must remain static for 10 to 15 years; thus, landlords may miss out on potential revenue growth.
The same is true for office and big-box retail building owners tied to long-term leases that are not indexed to CPI.
- Office – The future of office buildings is still in question. Fortunately, Moody’s Analytics reported that vacancy rates from all regions across America have not fallen beneath their pre-pandemic levels from Q4 2019.
To make a return to offices tantalizing for employees, some locations may benefit from reorganizing floor plans for improved collaboration and providing onsite private outdoor spaces and childcare and catering services.
When to consider holding
The Federal Reserve’s bold monetary policy will lead to higher long-term interest rates, resulting in an economic downturn and more stringent business lending standards. As a result, investors can expect lowered earnings due to these heightened costs and diminished property values.
For investors who are nervous about the current state of the economy but still have assets they plan on selling, it may be preferable to hold off until times turn around.
The decline-recovery cycle often stretches across a decade or more. This means that younger investors (under 50 years old) can afford to wait for the next market upswing in case of a significant correction.
The good news is that commercial real estate has a record of outdoing the S&P 500 indices, with an average annualized return rate of 10.3% over 25 years (much higher than the 9.6% index returns during that period).
What’s more, unlike stocks and bonds or even cryptocurrency markets, which can become worthless overnight, real estate values have never gone down to zero.
When to consider buying
Young investors may also consider buying CRE if there is a solid opportunity. Although interest rates are being adjusted upwards to manage inflation, they remain historically low. With these current rates, buyers who secure fixed-rate debt on rental properties will be one step ahead of the game.
With acquisitions made before the pandemic at excessively optimistic prices, many defaults are expected when the loans reset to higher rates and debt service can no longer be fulfilled.
When to consider selling
Many industry specialists believe that commercial real estate values have hit their peak. Recognizing that cash is king when a recession looms, some investors are making strategic sales and leasebacks—particularly in the medical and industrial CRE segments.
For CRE owners with management-heavy assets such as single-family rentals, smaller apartment blocks, and manufactured home communities, now may also be an excellent time to take some time off, travel, and enjoy the fruits of their labor.
Using IRS Code Section 1031, you can exchange these investments for total net single-tenant retail with access to historically low-interest rates and no capital gains tax.
The war in Ukraine, inflation and interest rate hikes, and overall economic volatility may cause 2023 to be an overwhelmingly difficult year for the commercial real estate sector.
Predictions signal that, barring a change by the Fed, GDP expansion will decelerate because of tighter monetary policy and global economies adjusting to higher consumer prices. This could result in reduced credit and lending opportunities and persistent asset pricing fluctuations.
But those who have been in the CRE industry long enough know that commercial real estate tends to fluctuate over time. Investors with secure financial balances understand how beneficial these sporadic hikes and drops can be.
For example, during an economic downturn, there is usually an increase in the number of overly-leveraged building owners. This presents a unique opportunity for investors and property owners who have prepared accordingly, ready to capitalize on the reduced prices for expanding their portfolio.
As this new year begins, stay ahead of the curve by reviewing your position and monitoring these 2023 commercial real estate trends and possibilities to make the best decisions.
Just one of the many reasons why Capital Investors Direct is rapidly becoming one of the most prominent commercial real estate loan placement and advisory firms in the U.S