If the nation slides into a recession this year, commercial real estate investors could see their annual returns shrink slightly or plummet into negative territory, depending on property type and the severity of the economic storm, according to Property & Portfolio Research.
Apartment owners are better positioned to hold the value of their real estate holdings through a mild recession than owners of office, warehouse or retail properties, but will likely experience a greater drop in net operating income (NOI), says Hans Nordby, PPR’s director of U.S. market research.
“What benefits apartments [in a recession] is that everybody believes in apartments as a good port in a capital storm,” Nordby says. “While the NOIs on apartments have a lot of volatility in a recession, the cap rates are well-supported by investors.”
For office, warehouse and retail properties, net operating income often continues to improve through a mild recession due to lease terms that average about five years for those property types. Even if a landlord has to lower the asking rent on a property, tenants renewing a lease will still end up paying more than they had been paying over the course of a lease term that is rolling over. NOI, therefore, remains positive. Not so for apartments, where leases are renewed each year at market rates and the effects of recession are more immediate.
Investors tend to favor apartments as a safer
Differences in annual returns by property type in either a mild or severe recession are the subject of alternative forecast scenarios PPR has prepared for its clients. To be clear, the company’s baseline forecast still calls for slow economic growth in 2008 without a recession, which is defined as two or more quarters of negative GDP. In response to client requests, however, PPR reran its models to see what returns would likely be under more dire conditions.
Retail is the only one of the four major property types that would drop into negative annual returns in the event of a mild recession. That model shows retail entering negative return territory this summer, dipping to a 2% loss for 2008 and gradually recovering to positive returns in 2009. Every property type would suffer negative returns in the event of a severe recession, but retail would bounce hardest with annualized losses of nearly 6% in the summer of 2009, recovering with break-even returns in the summer of 2011.
Unlike the early 1990s recession when retail properties performed well, recent deliveries andscheduled to deliver this year have primed the sector for a hard fall in the event of a recession. “Retail gets creamed in both a light recession and a severe recession,” Nordby says.
Hopefully PPR’s baseline projection will prove the most prescient, with soft returns of about 4% that gradually improve to about 6% by the end of 2012.
Will there be a recession in 2008? The consensus on Wall Street puts the likelihood at 40% for the year, according to Zanny Minton Beddoes, U.S. economics editor at The Economist. Recession risks are rising, Beddoes told attendees at a presentation on the national economy today in Austin.
Whether or not the economy meets the technical definition of a recession doesn’t matter, because even a slow economy will feel like a recession to consumers, Beddoes says. She predicts further declines in housing construction and home prices, followed by a lengthy period of lackluster economic activity leading into a slow recovery. Nevertheless, a correction is necessary, she says. “This is not a story of disaster,” she says. “It is an unwinding of excesses; it’s a necessary adjustment.”