MARKET INTEL: CRE Headwinds – Rising “IRE”: Inflation, Interest Rates, and Employment Cuts

 

And Small Business Sentiment is in steep decline under the conditions of this “IRE” economy (rising Inflation, rising Rates and rising Employment cuts). According to the NFIB’s Chief Economist Bill Dunkelberg, “the National Federation of Independent Business’s Small Business Optimism Index dropped in June to 89.5, marking the sixth consecutive month below the 48-year average of 98. Small business owners expecting better business conditions over the next six months decreased seven points to a net negative 61%, the lowest level recorded in the 48-year survey. Expectations for better conditions have worsened every month this year. As inflation continues to dominate business decisions, small business owners’ expectations for better business conditions have reached a new low.”

Changes in Housing Metrics and GDP Suggest a Recession is Ahead: Two additional economic measures reflect the negative impact of inflation and interest rate hikes.  The first is housing. When housing prices have risen rapidly as they have over the last two years—the median home price is up by more than 40% in less than 2 years and the average mortgage payment has increased from $1,500 to $2,500 as a result of home price and interest rate increases— the housing industry contracts. Since housing is a substantial part of the United States Gross Domestic Product (GDP) calculation, any drop in housing also leads to a contraction in GDP.;

To date, GDP has contracted from +6.9% in Q4 2021 to -1.6% in Q1 2022(percentage change from preceding quarter). GDP also dropped for the second consecutive quarter in Q2 2022, falling 0.9 percent based on the latest estimate, suggesting that the U.S. may be in a recession soon, if it isn’t already.

Housing starts and permits in the United States continued to fall in June 2022 amid higher interest rates and sharp declines in demand because of elevated housing prices. According to data released on July 19, the U.S. Census Bureau reported that there were 1.56 million new housing starts in June 2022 on an annualized basis, a 2.0% decline from May and the lowest level since last September. This level of housing starts is considered to fall well below the level needed to keep pace with long-term demand. RSM US LLP estimates that 1.7 million new starts are needed to meet this demand

A Recent Rise in Unemployment Claims Suggest a Softening in the Job Market is Underway: While the unemployment rate has remained a steady 3.6% for the last several months, a recent uptick in company job cut announcements is telling a different story. Initial unemployment claims rose for three consecutive weeks in July before falling slightly for the week ending July 23. Still, they are at their highest level since November 2021, with 256,000 claims filed last week. A slew of companies in the tech sector have announced cuts over the last several months and other major firms like Apple and Google have signaled that they will slow hiring amidst concerns of an imminent economic downturn. However, perspective is in order, weekly claims peaked at 6.2 million during the COVID-19 recession from March to April 2020 and at 665,000 during the Great Financial Crisis.

What Does the “IRE” Economy (Rising Inflation, Rising Rates, Rising Employment Cuts) Foretell for Commercial Real Estate (CRE) in the Second-Half of 2022?

Thus far in 2022, commercial real estate has escaped the material adverse effects from FOMC interest rate hikes. Rent growth and absorption in the Multifamily and Industrial sectors have been net positive.  Cap rates and Property prices have not gone the path of the major stock market indices to date. According to the Green Street Commercial Property Price Index (CPPI), commercial real estate prices have risen over the past 3 and 12 months, however, they declined by 3.7% in June 2022. The all-property index is now down 4.9% from its March 2022 high. Does this turn in CPPI foretell that commercial real estate is the next asset class to feel the impact of rising Inflation, rising Interest Rates and a slowing economy as most recent corporate earnings reports have demonstrated?  

For indications of increasing stress in CRE, Red Shoe Economics looks to CompStak to monitor changes in commercial sectors from its best-in-class leasing transaction data. In an upcoming part 2 blog and the September 15 webinar, we will touch on the following questions and more using CompStak’s data with a focus on the office and industrial sectors:

1. Industrial – Industrial rent growth has outpaced inflation for now…what markets have seen the strongest rent growth and are there any corridors/markets poised for additional growth or some contraction?

2. Industrial – Could Amazon’s pullback in industrial space impact rent growth? 

3. Office – Have lease terms recovered from pandemic lows, especially in Gateway Markets? Is there any indication that lease terms are shortening again as companies deal with uncertainty in the economy?

4. Office – What secondary markets have strengthened over the last two years?

5. Office – Would an economic slowdown impact the recovery to date in Gateway markets? What is the spread in performance between quality space including new construction and older, Class B and C product and will this bifurcation continue?

6. Is rising inflation and construction costs impacting lease terms, especially expenses and tenant improvement allowances?

In summary, no commercial real estate is not expected to go the path of the major stock market indices of late; however, headwinds are in the CRE forecast. Not all markets will perform the same and more strain is expected in high-cost West-coast and Northeast concentric MSAs. The key question to focus on is: Where can one outrun inflation?

^{Written by: KC Conway, Principal/Co-founder of Red Shoe Economics}