Inflation, interest rates and recession represent a triple-headed threat
Like the single-family sector, multifamily and commercial real estate have taken a financial hit amid volatility brought on by inflation. A veteran of CRE broke down what’s driving the challenges in sectors once considered red hot for investment.
Joseph Rubin, senior advisor at EisnerAmper’s real estate practice, recently spoke to Mortgage Professional America on the threats to the two sectors. The threat is three-pronged, comprising inflation, interest rates and recession.
What is causing inflation?
Rubin began with what he considers the “root problem” of inflation. “What began as a pandemic-induced trend seems to want to hang around, despite all efforts of the Fed,” he noted. “And the main ongoing driver is wage gains – about 4.8% in 2022 – which of course is good news for American workers but not so great for policy makers.
“Other long-term inflation drivers include de-coupling from China and de-globalization generally, growth in spending power and demand from major emerging economies such as India, the continuing uncertainty over global fuel costs due to geopolitical turmoil, and the reduction in the Fed’s balance sheet.”
In spite of such challenges, Rubin offered, the worst may be over in light of inflation easing. But then there are those pesky operating costs, he noted. “Despite the good news, property owners are feeling the impact of rising operating costs. Higher wages and insurance costs are long-term shifts, while utilities and building materials and supplies remain volatile. These higher expenses are shrinking property cash flows and increasing the need to raise rents, which is becoming increasingly difficult in many markets.”
How bad are interest rates right now?
Interest rates represent another challenge, relegating real estate as the “collateral damage” in the war against inflation according to Rubin. “We don’t need to reiterate here how significantly interest rates rose in 2022,” he observed. “And rates will likely keep rising for much of 2023. That means investors must pay more to get the same, even as values fall. Without free money, the price of all classes of assets must reset. Only a wave of new liquidity can prevent capitalization rates from widening, and with the direction and longevity of higher rates so uncertain that does not appear to be happening.”
Rubin noted the markets are predicting that rates will start to decline this year. “But the Fed’s dot plot suggests otherwise – the Fed Funds rate reaching 5.1% at the end of the year,” he said. “It seems strange that the market thinks it knows better than the folks who actually set the rates. Relief is likely not short-term and all players in commercial real estate will have to adjust to the new reality.”
The adjustment will be painful for some, he said, particularly those with floating rate loans that were not properly hedged. “Uncertainty over the direction of rates has lifted the price of interest rate caps to over ten times what they were a year ago.”
Is the US in a recession now?
The specter of recession is yet another worry, posing as a potential threat to recovery. “The range of projections of whether and when we will enter an economic recession is extraordinary,” Rubin noted. “Culling through the noise, the consensus seems to suggest a recession later this year that will be relatively benign. After all, the job market is amazing and GDP growth has been remarkably resilient at an almost 3% annualized rate in the fourth quarter of 2022.”
Talk of recession invariably makes businesses and individuals nervous, tending to reduce demand for space, Rubin observed. “If we have a more significant economic recession, the real estate industry will have to deal with falling demand, slower leasing, and falling rents on top of coping with a higher cost of capital,” he said.
“Any further reduction in demand could be the straw that breaks the camel’s back for the office sector, already suffering from tenants wanting to shrink their footprint. The hotel business, which has thrived during the past year, could be hampered by a pullback in leisure travel once the “R” word is uttered by the powers that be.”
Rubin observed the brief time in which the markets were thrown into uncertainly given market volatility: “In only one year, the formerly robust multifamily and commercial real estate sectors became entangled in a web of demographic, geopolitical, and economic dynamics that are interconnected and complex, creating an atmosphere of uncertainty and risk, threatening investment yields and property values, and constraining liquidity and transactions,” he noted. “The longer the uncertainty, the greater the likelihood of distress.”