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Over the last year, concerns about market uncertainty have grown among developers, as commercial real estate and the economy are deeply intertwined. Economists and investment professionals remain divided on the current commercial real estate market outlook, and it remains unclear whether or not the economy will go into a full recession.
The interplay between commercial real estate and the economy is largely related to market expansion. Economic growth, essential for healthy markets, is driven in a significant part by commercial real estate development. The NAIOP research foundation’s report on the “Economic Impacts of Commercial Real Estate” found that in 2022 new commercial building development and operations of existing building developments in the United States contributed $2.3 trillion to U.S. gross domestic product (GDP), generated $831.8 billion in personal earnings, and supported 15.1 million jobs.
Market expansion is equally necessary for commercial real estate’s success, as economic growth drives demand for housing, retail space, industrial infrastructure, and office space for added jobs. When the market is in a state of uncertainty, investors are more risk-averse as well, making it more difficult for developers to finance ambitious projects. The interplay between real estate, financial institutions or lenders, and the job market, make it important for development teams to keep an eye on the conditions shaping the market.
Unusual circumstances are contributing to the current uncertainty in the commercial real estate market, including efforts to quell COVID-19 era inflation, the collapse of Silicon Valley and Signature banks, and persistent office vacancies. Here’s how developers can better understand what the impact of a non-occurring recession might be on commercial real estate, continuity strategies for an uncertain market, and the tools or technology development teams can use to prepare for a recession.
The Impact of Economic Uncertainty on Real Estate Development Operations
COVID-19’s economic disruptions continue to be at the root of the commercial real estate market’s unusual outlook, especially the pandemic-era inflation caused by supply chain disruptions, labor shortages, surges in consumer spending, and other unexpected pandemic factors. The Federal Reserve, in an effort to stop inflation from becoming entrenched, raised interest rates to a range of 4.25% and 4.5% in December, and officials have hinted rates could top out at 5-5.25% next year. Higher borrowing costs put a particular strain on commercial real estate development, making it more difficult to secure funding and forcing some teams to consider delaying or canceling projects.
Empty office buildings, caused by the era of remote work COVID-19 precipitated, are also a source of economic anxiety. The Fed expressed concerns about commercial real estate, with a focus on office space, in the twice-annual Financial Stability report in May. The increased interest rates raise the risk commercial borrowers will not be able to refinance loans once the loans reach the end of their term. Office space vacancies rose to 18.2% by late 2022, topping 20% in major metropolitan areas like New York, Atlanta, and San Francisco, which may become an issue at the refinancing cliff. Higher vacancies mean buildings are worth less, and banks will only offer tougher terms, meaning these Class B office buildings remain a point of economic concern.
Developers can expect economic uncertainty to impact operations at all stages of the project lifecycle. Higher interest rates and recession fears are likely to make lenders more skittish. Inflation and ongoing pandemic-related supply chain disruptions may also result in unexpected costs in the construction phase, putting projects at risk of being delayed or running over budget. Rents can also be impacted by economic uncertainty, and businesses continuing to downsize office space or convert to a remote working model emphasize the need for a diverse portfolio to mitigate the financial risk.
Market uncertainty is expected to persist throughout 2023, and the pessimistic view is the economy will slow drastically under tightening monetary policy and enter a recession before the Federal Reserve stops raising interest rates. A more optimistic perspective posits the strength of consumers and resilient business might leave the commercial real estate market outlook seeming more positive. Commercial estate developers should prepare for all contingencies, shifting planning, and strategies to ensure success, whether or not a full recession does occur.
What Happens If a Recession Doesn't Happen: The Continuity of Real Estate Development
Overall, the commercial real estate market outlook seems relatively positive, with certain asset classes continuing to perform well. Even the Fed's Financial Stability Report findings stopped short of a full warning. The report, which surveyed broker-dealers, investment funds, research and advisory organizations, and other real estate stakeholders, ranked commercial real estate as the fourth-biggest financial stability concern impacting the current economy. Federal Reserve officials remain adamant the Silicon Valley Bank and Signature Bank failures, a source of anxiety for Wall Street, are somewhat irrelevant to the real estate industry, as the banks had less than 1% of assets in commercial real estate.
Deloitte surveyed 450 chief financial officers of major commercial real estate owners and investors for a “2023 Commercial Real Estate Outlook,” and in the survey, commercial real estate leaders remained optimistic about real estate fundamentals. Most respondents, about 66%, expected to see stable or improving conditions for cost of capital, capital availability, property prices, leasing or transaction activity, and rental rates.
In the absence of a predicted recession, developers can make several strategic decisions to take advantage of market opportunities and continue to build portfolios. Budgeting for uncertain times or ensuring a development team will have an adequate contingency in case of unexpected obstacles can also help developers make it through the current moment. Creating a comprehensive budget in the planning stages can help developers continue to pursue new and exciting projects without risking major overruns and financial peril should a downturn occur.
Emerging real estate development technology can also help developers navigate an uncertain economic moment, empowering teams to maintain a firm grip on the aspects within their power to manage with tools that take advantage of automation, data analytics, and proactive intelligence to keep budgets lean and project schedules met. Ensuring your team is operating in a cost-effective and efficient manner during a market without a recession will mean your business will be prepared to withstand any future downturns.
Even if the commercial real estate market outlook ends up being more positive and the economy doesn’t go into a recession, it’s important for developers to keep budgets lean, pursue projects with multiple revenue streams to mitigate risk, and leverage modern real estate technology to prevent timeline disruptions.
Preparing for a Recession as a Real Estate Developer
Developers should be prepared to weather the most pessimistic commercial real estate market outlook, implementing strategies to overcome funding obstacles, building a portfolio of diverse assets, and planning for future endeavors when the market turns around.
High-interest rates are one of the biggest concerns for real estate development teams. In the funding stage of a project, developers may struggle to raise capital. Work on building strong relationships with financial partners, as these partnerships will be valuable to raise funds for projects, regardless of economic conditions. Making it easy for financial partners to review key project financials, and offering real-time information on projects underway, can help bolster these connections. Maintaining the confidence of stakeholders will allow developers to operate more effectively during a recession.
Diversification is key to helping developers weather an economic downturn, as certain assets will be more susceptible to an economic downturn. Developers can also pursue recession-resistant properties, such as life sciences buildings, medical or healthcare facilities, or self-storage. Mixed-use developments remain an attractive opportunity for developers and investors even amid an economic downturn, helping diversify income streams to mitigate financial risk and increase long-term returns on the project.
Historical data can be a powerful tool in a difficult market, improving decision-making during a difficult economic moment with access to data about project scope gaps, vendor bids, vendor performance, contingency utilization patterns, and more. Data helps developers earn the confidence of stakeholders in the funding stage of a project and prevent any unnecessary overruns at a time when a lean budget is crucial.
Long-term planning can also be useful for developers facing an economy in recession. Commercial real estate conditions move in cycles, and recession-era conditions won’t persist forever. Developers should keep an eye on the future, looking for opportunities to grow once the economy stabilizes and enters a more positive phase.
The current commercial real estate market outlook is uncertain, and the interplay between commercial real estate development and the economy means developers should pay close attention to market conditions and plan for a recession as necessary. Technology can play a key role in helping developers navigate economic uncertainty, helping them maintain key financial partnerships and operate in the most cost-effective, efficient manner possible.
Looking for more tools and strategies to weather an economic downturn? Download the Maximizing Returns: A Real Estate Developer Recession Guide for more insights about maximizing returns, even in challenging times.
Tag(s): Real Estate Development
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