Are you prepared for the next recession?

What should owners and tenants do in preparing for a possible recession?

by Ryan Severino — (Originally published in the January/February 2019 issue of BOMA Magazine.)

The clock on this economic cycle is ticking. Unfortunately, it’s impossible to know exactly when the alarm will sound. But, with the current expansion lasting nine and a half years, we almost surely stand closer to the next recession than the previous one. During the last cycle, many got caught flat-footed—not just by the magnitude of the recession, but by its timing. Even without a perfect crystal ball, we can look at previous downturns and glean useful information that can help the commercial real estate industry prepare for the eventuality of the next downturn.

Where Are We Now?

As we head into 2019, the U.S. economy will be nearing 10 years of virtually uninterrupted expansion. If we reach midyear without the economy backsliding into a recession, which seems likely, then the current expansion will set a record for the longest economic expansion in U.S. history. That would be especially impressive given the depths of the previous recession. While some have maligned the current expansion for being weaker than previous ones, those criticisms generally stem from a misunderstanding of the underlying fundamental characteristics of the current economy.

Economic growth in 2018 clocked in around 3 percent, which would be the strongest during the current expansion and the fastest rate of growth since 2005. It also would mark the third time since 2000 that economic growth has reached at least 3 percent. Fiscal stimulus, via tax cuts and spending increases, fueled the economic surge. By some other key measures, the U.S. economy looks stronger than it has in roughly half a century, particularly in the labor market. The unemployment rate recently reached a level unseen since the late 1960s. Employment growth continues to generate impressive results, with net new job creation in 2018 averaging roughly 220,000 per month. Meanwhile, wage growth, often cited as the key sign of weakness in the labor market, has broken above 3 percent, long cited as an important threshold in the market. And, despite the U.S. Federal Reserve continuing to raise rates throughout the year, monetary policy (and broader monetary conditions) remain accommodative to economic growth.

Generally, these trends should persist as we head into 2019. Although fiscal stimulus is already fading, its impact should still reverberate throughout the economy. The labor market should continue to tighten, with job growth persisting well above the rate required to slow things down. The unemployment rate should continue to head lower, drifting down toward (but likely not reaching) 3 percent. Nonetheless, that downward trend in the unemployment rate should continue to put upward pressure on wage growth, which should head toward the mid 3 percent range. As it does, it is likely to apply upward pressure to inflation, which has, thus far, remained near the Fed’s target rate of 2 percent.

What Should You Watch For?

With so many things going well, what could go wrong? The headwinds for the economy are strengthening, even if markets have a propensity to overreact. Global economic growth, once a significant tailwind for the U.S. economy, is slowing; in different regions and across both developed and emerging markets, signs of a slowdown are becoming more abundant. The impact from fiscal stimulus already is fading. Its impact on economic growth abated throughout 2018 and is expected to keep lessening in 2019. Despite the tumultuousness of the markets, the Fed is likely to continue raising rates in 2019. Although the number of increases cannot yet be determined because the Fed will increasingly take its cues from the data, it seems unlikely it will completely halt rate increases because the labor market will remain too tight. The unemployment rate should continue to drift lower; wage growth should nudge higher.

Ultimately, that means one of two things. As wages increase, the cost will either get passed on to consumers in the form of higher inflation or corporate margins will shrink. Generally, companies do not prefer to see their margins erode, so they pass cost increases on to customers and push inflation upward. Until recently, wage growth has not caused much concern because it had been relatively weak. But, with wage growth accelerating, the probability of companies having to do something about it is escalating.

As core inflation creeps higher, which, barring a shock, should occur, the Fed will remain under pressure to keep raising rates. While low inflation often gets cited as a key reason to cease rate increases, lost in that reasoning is the role that higher rates over the last three years has played in keeping inflation in check. If the Fed eases up on rate increases, it raises the prospect that inflation accelerates. Therefore, expect the Fed to keep tightening in 2019, even if it is forced to back off its previously published forecasts for rate increases. These rate increases are designed to restrain wage growth and inflation, but also should restrain the economy in the process. With the Fed raising rates, the dollar should remain strong, making exports relatively more expensive and pulling back on net exports. And, trade policy, though subject to the whims of politics, remains restrictive. Unless the United States and China reach a grand détente, which seems unlikely, trade restrictions also will reduce economic growth in 2019 versus a base case with no trade impediments.

The prospect of an outright recession in 2019 looks low, but a slowing in the economy looks increasingly likely. That has rattled some participants in the commercial real estate market because of the procyclical nature of that specific market: It tends to perform better when the economy fares well and worse when the economy struggles. Therefore, as the economy slows, particularly at this relatively late stage of an economic expansion, commercial real estate could face challenges that it has not encountered in a few years, even without a technical recession.

What To Do About It?

With headwinds growing, participants in the commercial real estate market are becoming more unsettled. Everyone, from investors and developers to building owners to property managers, faces rising uncertainty, especially on the policy front. Yet, participants can at least consider several key things now to prepare for any slowing or disruptions in the market.

On the capital markets front, market participants should contemplate a few key potential actions. All participants, but especially investors, should watch their leverage position. Leverage usage tends to peak heading into a recession, and this cycle is no exception. While leverage does not appear excessive during this cycle, at least in aggregate, combined balances often can mask issues at the individual property or fund level. Any investors pondering a sale should consider this: When commercial real estate markets turn down, cap rates can take roughly three years to return to previous levels from before a downturn, even though any technical recession would be far shorter. Therefore, once pricing turns and if investors have not sold, they should prepare to hold assets for a number of years or face the prospect of less attractive pricing—if not an outright loss.

Building owners and managers should pay close attention to their expiring leases over the next couple of years. Generally, across property types, vacancy rates already are rising, while rent growth is slowing down. An economic slowdown will almost certainly exacerbate these trends. Building owners and managers should look at their lease roll and see what strategic decisions they could make in advance of any slowdown that might help with their asset management strategy during leaner economic times. Obviously, tenants have a bit more flexibility. If they have an expiring lease, they can wait and see what happens to market conditions and then try to secure favorable terms during a period of market weakness, even if they pull a lease renewal forward in time. When a downturn in the market strikes, it generally takes roughly two years for asking rents to return to previous peak levels.

On the portfolio management and strategy front, investment managers should consider options they could take now to strategically position a portfolio in advance of any trouble in the market. It could be wise to consider allocating more money toward less volatile metropolitan areas. Then, if the cycle runs into trouble, capitalize on the weakness and consider buying more risk-tolerant assets when pricing and demand are relatively low.

Obviously, individual circumstances will dictate which, if any, of these actions are appropriate. But, market participants, if proactive, will not simply find themselves at the mercy of the market. Any slowdown or outright downturn can present opportunities, as well as problems. Anyone involved in commercial real estate should at least be thinking about what actions they could take, even if they ultimately choose to do nothing.

About The Author:

Ryan Severino is the chief economist at JLL, where he manages the economics team and is responsible for global and regional economic research, analysis and forecasting, as well as property market forecasting.

BOMA Magazine is the official magazine of the Building Owners and Managers Association (BOMA) International. It is a leading source for the latest news, issues and trends affecting the commercial real estate industry.