How will the global commercial real estate sector perform in an economic downturn? As inflationary pressures increase and interest rates rise, recession risks are intensifying in several G7 countries. Tarrant Parsons, RICS Senior Economist, considers how the changing macro climate might affect capital values.
Tarrant Parsons, Senior Economist, RICS
1 July 2022
The news flow surrounding the global economy has turned decisively weaker over recent months, with intense inflationary pressures causing ever greater concern for policymakers. Meanwhile, the rising cost-of-living will become an increasing burden on household finances and will likely take a significant toll on consumer spending going forward. On the back of this, some of the world’s largest central banks have already been forced into a noteworthy series of interest rate hikes of late. More importantly, these central banks are scheduled to tighten policy considerably further through the remainder of 2022. Consequently, debate has emerged around whether this action will tip some economies into outright recession, or, if a ‘soft landing’ can still be achieved despite these mounting risks.
Measures of consumer confidence have deteriorated substantially over the past couple of quarters. Oxford Economics’ tracker of global consumer sentiment has slipped to levels not seen since the depths of the pandemic. However, some leading indicators of activity are pointing to a more resilient picture. New orders, for instance, are consistent with a slowdown, rather than a collapse in economic growth, while the global composite purchasing managers index (produced by JP Morgan) remains in expansionary territory. In addition, labour markets remain solid, with the latest data on unemployment across the G7 showing an average rate of 5.1%, slightly below that found prior to the pandemic (5.4%).
Nevertheless, past experience shows that, given time, tightening in monetary policy is more often than not associated with economic recessions. Research conducted by Oxford Economics examined 42 periods of rising rates over the past 70 years (in the US, UK, Germany/eurozone, and Japan), and found those accompanied by a recession outnumber those with no drop in output by 2 to 1. Moreover, there was only one instance in thirteen rate hike cycles in which the headline pace of inflation had exceeded 7.5% and a recession was still avoided.
Given inflation rates are expected to move closer to the 10% mark in several G7 economies over the coming months, the current situation seems ominous.
Even so, the consensus view is that inflation will fade rapidly through the second half of 2023, providing much needed relief for policymakers and households. Of course, base effects will be playing a significant part in slowing the annual rate of growth, even though pricing levels will remain much higher than before. It should also be stressed that the persistent strength of inflation has consistently surprised forecasters over the past twelve months or so. What was initially described by many to be a transitory period of price increases appears to be becoming more ingrained with each month that passes. It could well turn out that a lot more monetary policy tightening is required than currently envisaged.
How commercial real estate will perform in a higher interest rate environment and, at the very least, a slowing growth backdrop, is a critical topic right now.
Feedback received from the Q1 2022 RICS Global Commercial Property Monitor (GCPM) strengthened across many nations. Respondents reported greater momentum coming through in terms of occupier activity. This in turn is helping to support an uplift in rental growth expectations. Investment demand also appears to have gained significant impetus thought the early part of the year. Key markets across the US, UK and Canada are seeing a noticeable pick-up in investor enquiries.
Looking ahead, it will be very interesting to see how much influence (if any) the recent increase in interest rates and gloomier macro outlook have on sentiment across the sector.
Feedback received from the Q1 2022 RICS Global Commercial Property Monitor strengthened across many nations. Respondents reported greater momentum coming through in terms of occupier activity.
Up until now, recent data from other sources has not shown any meaningful signs of the market slowing down. Take the UK for instance, capital values at the all-property level have increased by 19% over the past year according to the CBRE index. In fact, since turning positive in May 2021, this rate of growth has accelerated in thirteen consecutive months. Likewise, in the US, Newmark Research reported there was $171bn invested into the commercial property market in Q1, marking a record high for a first quarter of a year. Globally, their figures also show that commercial real estate investment volumes, on a twelve-month rolling sum, have increased by 42% year over year, with $2.3trillion invested across the world. As such, the market is clearly starting from a point of strength and the rest of this year may well continue to deliver relatively strong returns when placed in a historical context.
Further ahead however, the impact of higher borrowing costs will likely become more prominent next year and beyond. This has led Capital Economics to forecast that total returns across the United States will fall to zero in 2023 (from an expected 8% in 2022). This would in part be driven by a decline in capital values of roughly -4% next year, while values are also seen slipping by -1% the following year. Accompanying this, yields are expected to rise by 45 basis points between 2022 and 2026, trending upwards to a greater or lesser degree across all sectors. In truth, although such an outcome would mark a stark departure from the recent buoyancy of the market, it could still be considered something of a softer landing. Looking back at previous downturns across commercial real estate, much more significant corrections can be observed. In the UK as an example, over the past 50 years, Morgan Stanley research shows there have been three corrections (occurring every 15 years or so) in which capital values have fallen by more than 50% in real terms.
That’s not to say a correction is the most likely scenario going forward. In many markets, the structure of commercial real estate investment financing has changed materially over the past decade. As an illustration, bank lending to UK CRE, as a portion of total UK bank lending, has fallen from 10% back in 2008 to around 5% currently. Consequently, changes in banks’ appetite to lend to the sector have less influence on capital values than before.
Either way, the coming quarters will provide more information on the future direction of travel. The RICS GCPM data has an excellent track record of depicting turning points ahead of the hard data releases. Its future results will be all the more important in signalling the near-term outlook for market conditions.
