The political discussions about what constitutes a recession have been lively this year, to say the least. But whether we have been living in a recessionary period or are simply enduring a slow-growth recovery, commercial real estate investors should understand how economic downturns may impact their investment decisions.
What’s in a Word?
While the definition of a recession might be debated among political rivals, the first two-quarters of negative real economic growth in 2022 would traditionally indicate that we entered a recession. The combination of stubbornly high inflation and the Federal Reserve’s policy of raising interest rates to help curb inflation has undoubtedly slowed the U.S. economic recovery from the pandemic.
For real estate investors, the question is, to what extent does a recession affect income distributions and property valuations? In this discussion, we address several factors to consider regarding a recession’s impact on commercial real estate (CRE). We also highlight how private real estate investments, represented by the NFI-Open-End Diversified Core Equity index or NFI-ODCE index, pronounced “Odyssey” for short, in our opinion may be better positioned to withstand an economic downturn than other CRE investment structures.
This Time It’s Different
Legendary investor Sir John Templeton is credited with saying, “the four most expensive words in the English language are, ‘this time it’s different.’” He likely referred to investors’ propensity to repeatedly rationalize their emotional investment decisions.
For today’s CRE investors, there may be a tendency to believe that the 2022 economic downturn will not affect investment performance. After all, CRE is generally regarded as a good inflation hedge, with landlords able to raise rents (either via short-term lease renewals or contractual increases tied to the CPI) as their operating costs increase.
And if inflation occurs because of strong economic growth, vacancy rates generally remain low, and rents remain high. But two-quarters of negative GDP growth would indicate our economy may not be as strong as some suggest. And in that case, certain CRE investments and property types may be exposed to the potential for either a decline in revenue or falling property valuations.
In a Recession, Does Property Type Matter?
Among the big four CRE property types - office, retail, apartment, and industrial – the industry has seen dramatic changes in investment flows in the last few years due to the disruptions caused by the pandemic. Once dominant sectors, office and retail were strong performers before the COVID outbreak yet took the biggest performance hits during the lockdowns. Conversely, apartments (an “essential” asset class) and industrial benefited from increased investor interest and delivered strong returns during the pandemic.
Today, office property owners who are still trying to understand the full impact of the work-from-home revolution may be in for additional headwinds with tenants looking to reduce their leased space as a belt-tightening measure amidst a slowing economy. Similarly, retail and hospitality sectors may see revenues and earnings decline as consumers cut spending.
Public or Private Real Estate
You might think the type of commercial real estate investment structure you use when allocating client portfolios wouldn’t make a difference in how it might perform during a recession. But, while public and private real estate investments may own the same types of commercial properties, their structures are subject to different market and economic conditions.
For example, publicly-traded CRE investments like REITs, real estate mutual funds, and ETFs are generally considered liquid investments allowing you to trade in and out of positions with relative ease. But on the other hand, these investments often behave similarly to equities, especially in volatile markets, and may not provide the portfolio diversification benefits you would expect from an uncorrelated asset class.
Private real estate (PRE), however is uncorrelated to publicly-traded securities and not subject to the same market influences as stocks, bonds and public REITs. The NFI ODCE index (ODCE) is widely used by institutional investors as a proxy for core private real estate investment performance, and the requirements for fund inclusion in the index may help illustrate with core PRE funds could be well positioned to help withstand challenging economic conditions.
For example, fund managers included in ODCE must adhere to the following investment rules that may help benefit investors:
Diversification: 75% of the market value of real estate net assets must be invested in office, industrial, apartment, and retail properties, with no more than 60% in a single property type.
Leverage: No investment properties held within a fund can have more than 35% leverage. Over-leveraging, as you recall, was a principal reason why many commercial properties were foreclosed on in the Great Recession.
Quality: ODCE funds can only own “core” real estate, generally characterized by their institutional quality properties, low vacancy rates, and investment-grade tenants. If commercial real estate is negatively impacted in a recession, core private real estate properties would generally be the least affected.
Investors cannot invest directly in an index.
The Daylight Ahead
Commercial real estate, like most investments, is not immune to the economic impacts of a recession. And while certain property types (industrial, apartment) and investment structures (private) may be better positioned to withstand a reduction in cash flow or declining property valuations, it’s essential to recognize that a slow-growth economy can present challenges for CRE investors.
The good news is that CRE operates in cycles. So even if property valuations decline in a recession, distressed sellers can create a buyer’s market, allowing well-capitalized investment management firms to invest at the bottom of the cycle and create investor value in the recovery phase.
If you want to learn more about ODCE and private real estate investing, download your complimentary guide, Made for Income: An Advisor's Guide to a Durable Income Alternative, or call us at 833.768.0622 with any questions.