Although opinions vary on whether the U.S. Federal Reserve Board can successfully manage a “soft landing,” many in the commercial real estate industry are bracing for a U.S. recession in 2023.
The Fed has been crystal clear in its commitment to fight high inflation by raising key benchmark rates and reducing the size of its balance sheet with quantitative tightening. The ultimate goal is to slow the economy and not crash it.
“I think everybody does see a slowdown coming, although some optimistic people think it can be achieved without high unemployment,” says Christine Cooper, chief U.S. economist and a managing director at the CoStar Group.
“I don’t think a recession is inevitable. I still think there is a path to a soft landing, but admittedly that path is getting narrower and a lot of this will come down to the Fed and how aggressive they’re willing to be,” says Ryan Severino, chief economist at JLL.
The ULI/PwC Emerging Trends in Real Estate® report predicted a “short and shallow” recession ahead for 2023. Many economists agree with that sentiment based on current data, but they also agree that a number of variables are still in play that could shift the timeline and trajectory. How high will rates go and how fast? How long will rates remain at a high level? At what point will the Fed start backing off on interest rates?
“My concern is not that the Fed has been raising rates, because I think that is appropriate. My concern is that they were raising aggressively and then not necessarily giving enough time for the rate increases to have an impact,” adds Severino.
The general expectation is that the U.S. economy will enter its contraction phase somewhere between December 2022 and April 2023 and then continue until 2024. “We do think it will be a moderate recession, although I don’t think we would be as precise as to say it will be short and moderate, because there are risks skewed to the downside,” says Richard Barkham, CBRE’s global chief economist and head of global research.
Although inflation has pulled back from highs of 9.1 percent in June to 7.7 percent as of October, the Fed seems determined to get inflation down to a low of 2 percent. That will require taking some of the “heat” out of the labor market and raising the level of unemployment, which remains historically low at 3.7 percent, notes Barkham.
Access Emerging Trends® and the most recent ULI Real Estate Economic Forecast on Knowledge Finder.
Slowdown Slow to Take Root
Rising interest rates are having an impact on slowing the economy, but that slowdown has been choppy with some sectors that are feeling the brunt more quickly than others. Rate-sensitive sectors such as home sales have been hit hard by the jump in mortgage rates. Existing home sales declined for the ninth month in a row to a seasonally adjusted annual rate of 4.4 million in October, down 5.9 percent from September and 28.4 percent percent from one year ago, according to the National Association of Realtors.
Although there is evidence of a slowdown in the U.S. economy in areas such as housing and manufacturing, it is a very gradual slowdown, notes Barkham. “There are many aspects of the economy that haven’t yet been touched by rising interest rates,” he says. Activity related to air travel and dining out remains robust, and retail sales have been surprising on the upside. Job growth is decelerating but still positive, pulling back from highs around 600,000 earlier in the year an estimated 263,000 jobs added in November, according to the Bureau of Labor Statistics.
Moody’s Analytics is estimating the chance of a slight recession at 50-60 percent, but a 2023 recession would be nothing like the Great Financial Crisis. Financial institutions have been relatively conservative on lending and underwriting, while businesses also have been cautious in their expansion and willingness to take on debt. So, even with higher interest rates, a significant swell of bankruptcies is unlikely, says Thomas LaSalvia, director of economic research at Moody’s Analytics. “That is a big difference in this cycle that’s going to prevent a cascade of economic stress,” he says.
Every recession or downcycle is somewhat unique in its characteristics and what industries are more or less affected. Economists are anticipating that the 2023 recession could be more of a white-collar recession. The economy is already starting to see the front end of that with corporate announcements of hiring freezes and layoffs. However, even with slowing the ratio of job openings to job seekers remains at nearly 2:1, which is pretty unprecedented, notes LaSalvia. Going into the last couple of recessions, that scenario was more the reverse. “So, there is a lot of softening the economy can go through without causing this tremendous labor market stress and without causing a swell of bankruptcies on the corporate side,” he says.
Oxford Economics is predicting GDP declines in the first two quarters of 2023 with declines that are more concentrated in interest-rate-sensitive sectors such as finance, insurance, and real estate, with a smaller impact on manufacturing and professional and business services. The firm also is forecasting shallow job declines in second and third quarters with job growth overall that will remain slightly positive at around 1 percent. “Finance, insurance, and real estate will take the biggest hits, but because of recent labor shortages, we do not expect massive layoffs,” says Barbara Denham, senior economist, cities and regions at Oxford Economics. Companies are concerned that if they let people go it will be difficult to get them back.
In addition, even though the media has been reporting looming layoffs in tech sectors for months, year-over-year job growth in every tech category–software, computer manufacturing, computer systems design, and data processing–was positive in October with growth ranging between 3 percent to 9 percent, adds Denham.
Rising Rates Weigh on Transactions
Rising interest rates are having a cooling effect on transaction activity. According to CoStar, transaction volume in October fell for the third consecutive month, dropping 27.2 percent to $43.9 billion compared to September. Data continues to show price appreciation, but that appreciation is decelerating and varied depending on the asset type and sector. CoStar’s value-weighted U.S. Composite Index, which is more heavily influenced by high-value trades common in core markets rose 2.6 percent in third quarter and is up 11.2 percent year-over-year. Meanwhile, CoStar’s equal-weighted U.S. composite index, which reflects the lower-priced property sales typical of secondary and tertiary markets, fell by 0.9 percent in the third quarter but remains 12.4 percent higher on a year-over-year basis.
Many investors have put pencils down amid interest rate volatility and the subsequent bid-ask gap that has emerged since the Fed began raising rates in March. “There is still this disconnect, and buyers are waiting to see prices decline a little bit more before they’re willing to take it on,” says Cooper.
Property values are still in a discovery period. “We think, on average, real estate values are down by approximately 15 percent across the board, and perhaps less so in multifamily and industrial and more so in office but it varies a lot by quality of asset and location,” says Barkham. “Retail is perhaps the most nuanced sector, with some sectors of the market, such as grocery anchored suburban centers, hardly impacted by rising interest rates.”
Varied Impact on Property Sectors
One of the factors that bodes well for CRE is that there hasn’t been excess building and a surplus of space that has existed in past cycles. So even if there is a slowdown in demand, fundamentals are likely to hold up generally well, but some sectors of the real estate market are better positioned than others. Multifamily and industrial have strong fundamentals and are likely to be viewed as more defensive investments in the near term. Although economic downturns often have a negative impact on household formation, the country is still dealing with a housing shortage that has been exacerbated by higher mortgage costs and affordability of homeownership for first-time buyers.
Moody’s is forecasting rent growth of 3.1 percent for multifamily in 2023, which is below the long-term average. “We are going to see a little bit of stress there for multifamily as this economy softens for a while before picking up again later in the middle of this decade,” says LaSalvia. It’s not that demand isn’t there, it’s an affordability issue, he notes. Rents are so high that people are pulling back and living with roommates to lower costs, or moving home with mom and dad, which is translating to lower absorption. The number of new units under construction also is at a historic high, and that new supply will likely contribute to some softening in rents.
Industrial has continued to benefit from strong secular tailwinds, including e-commerce, onshoring of manufacturing and revamping supply chains. Although there continues to be a robust development pipeline with roughly 550-600 million sf of new space that will be delivered in 2023, there is still considerable pent-up demand with national vacancy rates at 2.9 percent, according to CBRE. The flow of goods through the American economy is going to weaken during the recession, but e-commerce penetration will continue to rise in the longer term. “We do see vacancy rates going up in 2023 and rental rates coming down from peak levels in 2022. However, that is relatively healthy for the market because some companies have been constrained in what they are able to do,” says Barkham.
Although the slowing economy could take some of the wind out of the sails of what has been a good retail recovery, retail sales were strong heading into the holiday season. Retailers and restaurants put their foot back on the gas for expansion with strong leasing activity during 2022. “A lot of this leasing will continue even if 2023 isn’t a great year or even great first half of the year, because the longer-term trajectory is actually pretty good,” says LaSalvia. In addition, there is a lot of momentum behind lifestyle mixed-use centers with retail, office, and housing that are all co-existing. “I don’t think that stops in early 2023 just because of a mild recession, I think that momentum and evolution within retail will continue,” he says.
Office Sector Challenges
Even a mild recession is likely to bring added stress to the office market, which is still reeling from the lingering effects of the pandemic and the shift to remote and hybrid working. Current threats of layoffs will shift the balance of power more in favor of employers, but hybrid work is likely to remain a permanent aspect of the workplace. Both tenants and landlords are trying to figure out changing space needs in this new paradigm. The office market will remain in transition for a few more years, but more will return to the office over time.
That stress is evident in a rise in direct vacancies and available sublease space. Vacancies have been elevated ever since the pandemic and occupiers are still shedding space. Although there were roughly 1 million office jobs added over the past two years there is still significant negative net absorption. According to CoStar, sublease space is at record levels and net absorption has been negative for the past two years with totals of roughly -120 million sf. “We’re not very optimistic about the office sector because of the slow return to office and whether or not remote working is a permanent shift,” says Cooper. “Our forecast is for vacancy to continue to be quite elevated through the end of 2024 approaching historic highs exceeding those seen during the Great Financial Crisis,” says Cooper.
Across the broader commercial real estate market, a recession will likely create some softening in fundamentals and net operating income and slow investment sales and development activity. On the positive side, commercial real estate investors and developers are making decisions based on long-term hold strategies. Recessions are typically short-lived, and CRE investors are likely to treat a mild recession as a speedbump and not a roadblock, notes Severino.
“Even if we end up in some sort of slowdown next year, the good thing about our industry is that it does tend to think more broadly,” says Severino. “Once we see the shape of what next year looks like, you’ll see people thinking about how to manage for the other side of it in 2024, 2025, and 2026.”
BETH MATTSON-TEIG is a freelance business writer and editor based in Minneapolis.
