Commercial Real Estate Is Facing a Triple Threat: Interest Rates, Inflation, and Recession
September 08, 2022
Commercial property sectors, other than office, have recovered well after the shock of the pandemic. Generational demographics and a particularly robust job market have sustained demand, and rents and occupancy are continuing to rise, albeit at a slower pace than last year. The fundamentals are good, yet property investors are appropriately nervous. They face the triple threat of higher interest rates, higher inflation, and a high probability of recession, each of which will impact the performance of their real estate investments in different ways. As we mentioned in our commercial real estate mid-year review, these external factors are already slowing down transactions and impacting asset values, despite the otherwise superb performance of the properties themselves.
This is the first of a series of articles and webcasts addressing the changing real estate investment and operating environment driven by economic factors rather than supply and demand. Looking forward, investors in both equity and debt will be assessing the impact of these new dynamics on property cash flows and investment returns. Market participants will also be carefully watching whether the abundant capital available for commercial real estate for more than a decade will begin to recede as other investment alternatives provide more attractive risk-adjusted returns. Part of that equation is the relative weight of each of the triple threats to the industry; for example, will real estate’s role as an inflation hedge win out over the impact of higher costs of capital? These dynamics, currently unpredictable, will reveal themselves over the coming months.
As we noted in our mid-year review, interest rates to real estate are like fire to a scarecrow, and therefore the most potentially damaging of the triple threats. Owners with near-term debt maturities and investors looking to develop or acquire properties must reassess their deal economics as both rate indices and credit spreads widen. Lower yields and the uncertainty of the interest rate environment at the exit is causing investors to pause and rethink their strategies. Moreover, lenders are increasingly skittish about the impact on the debt service coverage ratio if debt service grows faster than net operating income. Less cash flow cushion and the potential for lower collateral value has already reduced the availability of debt capital, at least in the short-term. On a positive note, many loans with longer maturities, say seven-to-ten years, may be maturing in an interest rate environment similar to that when the loan was originated. As always, the impact is property by property, market by market.
During the past decade of artificially low interest rates and abundant capital, the spread between interest rates and capitalization rates has been remarkably wide, leading many to predict that there will be enough room for interest rates to grow without impacting cap rates. However, during the last few months of volatility and uncertainty we have already seen a measurable pick up in cap rates in selected markets and property types. As interest rates find their new equilibrium so will cap rates; commercial real estate performance and valuation will always remain cyclical. But the impact will be highly differentiated by the varying demand for space in particular markets.
Inflation will have a direct impact on property construction and operating costs, as the market has already experienced since early this year. Some higher costs have been driven by supply chain disruptions that have begun to moderate and will continue to seek equilibrium. However, some expenses are likely to remain high for the foreseeable future. Wages and benefits, in particular, appear to have reached a new plateau given an incredibly robust job market and ubiquitous worker shortages. Utilities are also likely to remain high due to geopolitical forces and more unpredictable and severe climate in many parts of the country. Climate change is also driving up the cost of property insurance.
Real estate as an inflation hedge relies on the ability to grow rent faster than inflation-impacted costs. That, in turn, is dependent on property type and market, and how frequently the operator can adjust rent (i.e., the length of the lease). During the last decade the stability of long-term leases was prized by investors, but now they are taboo unless the lease has frequent and meaningful escalation clauses. Owners of properties with short-term leases such as hotels, self-storage, and multifamily can most take advantage of an inflationary lift in rent. But that is only if there is increasing demand in the market against a backdrop of limited supply. In other words, the effectiveness of the inflation hedge depends on the right circumstances, most importantly being in a market with continued in-migration and job growth.
Recession is currently the least impactful of the triple threats because of the uncertainty the economy will shrink for a prolonged period, and because the strong job market is sustaining space demand. Unless a severe recession results in rapid and significant layoffs similar to the initial response to the pandemic, the current low unemployment rate and high number of job openings should even help cushion the hospitality and retail sectors from a downturn. To date, hotels are enjoying the highest average daily rates since the start of the pandemic and retail sales continue to grow. However, the psychological impact of a recession, most importantly the fear of losing one’s job, could dampen consumer spending, as could continued high inflation that forces households to save for necessities and reduce discretionary spending. Fear of stagflation could create a vicious cycle that makes any downturn more severe.
If a recession curbs corporate earnings, the office market will take another hit on top of already reduced demand due to the work-from-home phenomenon. As mentioned earlier, the office sector is the one area of commercial real estate with weakening demand, particularly for Class B and C properties that cannot provide the space design and amenities that tenants now require. Liquidity has drained away from the asset class, other than office-to-multifamily conversions, and many lenders have shied away from office loans since last year. The triple threat of higher interest rates, higher costs, and even lower demand create a perfect storm that will likely accelerate office sector distress.
Over the coming months we will continue to closely monitor the severity of each of the triple threats and their impact on commercial real estate, with the hope that interest rates and inflation stabilize and abate by the middle of next year and any recession that comes our way is mild. However, the problem for owner operators is the exogenous nature of these threats and the uncertainty that brings. Industry participants have no influence on these threats and therefore must wait and see – and most of all prepare. Additional articles in this series will be focused on those preparations in response to the changing real estate cycle.