Economic downturns pose significant challenges to the commercial real estate (CRE) industry. These periods of decreased economic activity can lead to reduced tenant demand, financial difficulties for CRE businesses, and declining property values. Understanding the impact of economic downturns on CRE and implementing effective business continuity planning is crucial for navigating these challenging times and ensuring long-term success. This report examines the historical impact of economic downturns on CRE, provides case studies of businesses that successfully navigated past downturns, and outlines resources and strategies for business continuity planning in the face of economic uncertainty.
Historically, the performance of the U.S. commercial real estate (CRE) sector has suffered during economic downturns. Recessions are formally defined as two consecutive quarters of negative economic growth1. They typically involve elevated unemployment rates, signifying broader economic downturns that can negatively impact several parts of the economy, including CRE. During and after the recessions of 1990-1991, 2001, and 2007-2009, CRE experienced higher vacancies, weaker cash flows, and lower valuations2. This decline in economic activity reduces CRE demand, resulting in negative absorption of space and higher office vacancy rates2. For example, a 10% default rate on CRE loans, similar to the lower end of defaults seen during the Great Recession, could result in approximately $80 billion in additional bank losses3.
Economic downturns also affect CRE investments. When the economy is thriving, with low unemployment rates and stable growth, investors are more likely to pour their money into CRE projects. A strong economy creates demand for office spaces, retail stores, and other commercial properties. On the other hand, during economic downturns...source
The impact of economic downturns on CRE is not uniform across all asset classes. Office space is the most vulnerable asset class. Office buildings, especially Class B and Class C spaces, are still facing high vacancy rates in the post-pandemic era and are therefore the most vulnerable assets in the event of a downturn4. Property owners are looking for creative ways to repurpose vacant office building assets with an unclear future, such as conversions into affordable housing or mixed-use developments4.
While recessions bring challenges, they can also create opportunities for businesses to acquire properties at lower prices or invest in distressed assets6. For example, during a recession, there may be a decrease in demand for commercial real estate, which can lead to lower property...source
It's important to consider the role of financial conditions in CRE performance. A one-standard deviation tightening in financial conditions is associated with a drop of about 3% in CRE prices in the following quarter, with a stronger impact on the retail sector7. This highlights the interconnectedness of the CRE market with broader economic and financial trends.
Furthermore, the concentration of risks from CRE downturns varies across financial institutions. Smaller banks tend to hold a larger proportion of CRE loans relative to their assets compared to larger banks8. This suggests that smaller banks may be more vulnerable to CRE downturns, while the overall systemic risk may be lower compared to larger banks.
The Federal Reserve (the Fed) plays a crucial role in influencing the CRE market, particularly during economic downturns. The Fed's monetary policy decisions, such as adjusting interest rates, can have a significant impact on CRE investment and lending activity9. For example, during the Global Financial Crisis, the Fed quickly lowered interest rates to stimulate economic activity and support the CRE market10. However, the current economic environment is different, with the Fed in a tightening cycle to combat inflation10. This suggests that the Fed's response to future economic downturns may be different, and CRE businesses need to be prepared for a potentially less accommodative monetary policy environment.
Examining historical data on CRE performance during past economic downturns provides valuable insights for understanding the potential impact of future downturns. The 2008 financial crisis, for example, led to a significant decline in commercial real estate values and increased vacancy rates10. The S&P 500 declined nearly 50% in late 2007, while commercial real estate property prices fell more than 30%10. Bank CRE loan delinquencies peaked around 4% in 2010, and losses peaked at around 1.2%. Cumulative losses were about 3.75% for the entire crisis11. CMBS delinquencies peaked at 7.1% in 201011.
It's important to note that no two downturns are exactly alike. The GFC was a real estate-driven decline in which the Fed quickly lowered rates to rock bottom levels compared to today's tightening cycle where real estate fundamentals remain generally strong10.
Here's a summary of key statistics from the 2008 financial crisis: 7
|
Variable |
Mean |
Standard deviation |
Minimum |
25th percentile |
Median |
75th percentile |
Maximum |
|---|---|---|---|---|---|---|---|
|
SalesPriceAmount |
$2,135,863 |
$14,396,319.6 |
$250,000 |
$392,500 |
$668,000 |
$1,450,000 |
$2,140,000,000 |
|
SalesPerSurface |
449.68 |
106,313.25 |
0.0 |
10.8 |
25.3 |
63.1 |
98,000,000 |
|
BuildingAreaSqFt |
29,710 |
98,200 |
0 |
3,917 |
8,632 |
21,966 |
12,657,192 |
|
LotSurface |
1,294,529 |
106,716,048 |
0 |
11,940 |
33,726 |
85,378 |
35,200,000,000 |
|
LoanAmount |
$2,645,936 |
$20,593,250 |
$0 |
$300,000 |
$515,500 |
$1,100,000 |
$1,000,000,000 |
|
LTV |
0.76 |
0.23 |
0.00 |
0.65 |
0.78 |
0.90 |
1.5 |
Despite the market volatility during the 2008 financial crisis, CRE debt performed relatively well10. The Giliberto-Levy Commercial Mortgage Performance Index, which tracks the performance of fixed-rate commercial mortgages, returned -4.41% through Q1 2022, as it benefited from a still solid backdrop for CRE investments10. This suggests a degree of resilience in the CRE debt market, particularly for senior loans that have priority in the capital structure.
Analyzing case studies of CRE businesses that successfully navigated past economic downturns can provide valuable lessons for business continuity planning. One such example is Xero, a cloud-based accounting software company founded in New Zealand in 2006. When the Global Financial Crisis (GFC) hit in 2008, businesses struggled, but Xero saw an opportunity. They recognized that small businesses would look for cost-effective and efficient solutions to manage their finances remotely. Despite...source navigate the economic downturn12.
Another example is Mainfreight, a New Zealand-based logistics company that faced significant challenges during the 2008-2009 recession as international...source solutions. This strategic shift allowed Mainfreight to weather the storm and emerge stronger from the recession12.
These examples demonstrate that companies can not only survive economic downturns but thrive by adapting their business models, focusing on innovation, and meeting customer needs12.
It's also important to consider examples from other industries that demonstrate resilience during economic downturns13. Accountants, for instance, often experience an increase in business during a recession as individuals and businesses require professional help to manage their finances and navigate new government regulations13. Similarly, healthcare providers often see continued demand for their services even during economic downturns, as healthcare needs remain essential13.
Furthermore, economic downturns can be a time of opportunity and innovation14. Many massive companies, such as IBM, Disney, and HP, were founded during recessions14. These companies were able to capitalize on the unique circumstances of a recession to establish themselves and achieve long-term success.
Other companies, such as Kellogg's and Booking Holdings, have survived past economic calamities by employing different strategies15. Kellogg's, for example, thrived during the Great Depression by investing more in advertising and its people, while Booking Holdings (formerly Priceline) focused on providing value and convenience to customers during the dot-com bust15.
Economic fluctuations are a natural part of the business cycle, presenting both challenges and opportunities16. While some businesses manage to adapt and thrive, others are less fortunate, succumbing to the pressures of inflation, recession, and changing market dynamics16. Understanding the factors that contribute to business failure and success during economic downturns is crucial for CRE businesses to make informed decisions and develop effective strategies.
During economic downturns, governments often implement support programs to assist businesses, including those in the CRE sector. These programs can provide financial assistance, tax relief, and other resources to help businesses weather the storm.
In addition to these programs, various government departments offer specific support for CRE businesses. The Minority Business Development Agency (MBDA), for example, provides financial assistance and resources to minority-owned businesses, including those in the CRE sector21. The EDA also offers programs specifically for coal communities that have been negatively impacted by changes in the coal economy19.
Business continuity planning is essential for CRE businesses to mitigate the risks associated with economic downturns. A business continuity plan (BCP) is a collection of resources, actions, procedures, and information that is developed, tested, and held in readiness for use in the event of a disaster or major disruption of operations22. A comprehensive business continuity plan will help you maintain your central business activities while limiting the economic impact and allowing you to return to normal operations as quickly as possible22. Proactive risk management and business continuity planning are crucial factors in mitigating the impact of economic downturns on CRE businesses22.
Here are some key elements to consider when developing a business continuity plan for your CRE business:
In addition to these general elements, CRE businesses should consider specific factors relevant to their operations. For example, labs and research facilities have unique needs, such as ensuring the proper care of animals and maintaining essential research materials, that should be addressed in their business continuity plans27. Similarly, universities, with their complex operations and diverse stakeholders, require a comprehensive approach to business continuity planning that considers the needs of all departments and units28.
Technological advancements and sustainability trends are playing an increasingly important role in enhancing the CRE industry's resilience to economic downturns5. Technological advancements, such as smart buildings and data analytics, can help CRE businesses optimize operations and reduce costs, while sustainability initiatives can enhance property values and attract tenants.
Smart buildings, for example, use sensors and data analytics to monitor and control building systems, such as lighting, heating, and cooling. This can lead to significant energy savings and reduced operating costs, which can be particularly beneficial during economic downturns when businesses are looking to cut expenses.
Sustainability initiatives, such as green building certifications and energy-efficient retrofits, can also enhance the resilience of CRE properties. Green buildings tend to have lower operating costs, attract tenants who are willing to pay a premium for sustainable spaces, and hold their value better during economic downturns.
Furthermore, the rise of generative AI is expected to increase the demand for data centers, which are a key component of the digital economy5. This presents an opportunity for CRE businesses to invest in data center development and capitalize on the growing demand for this asset class.
Expert opinions and forecasts suggest that the CRE industry may face continued challenges in the coming years due to factors such as elevated interest rates, high inflation, and shifts in how tenants occupy commercial space5. Deloitte's economics team projects that GDP growth for the remainder of this year will be faster than 2023 in India and Singapore, but slower in Mexico and Japan5.
The Counselors of Real Estate® and its 1,000 credentialed real estate advisors have identified the current and emerging issues expected to have the most significant impact on all sectors of real estate29. The Top Ten Issues Affecting Real Estate® are determined through broad membership polling, discussion, and debate29. The rate of change in the industry is rapid and—with many of the issues interrelated—the common denominators are people, goods, and money29.
Over $2 trillion of CRE-based debt is coming due in the next three years, which will need to be refinanced, and traditional lenders (mostly regional banks) may not be willing to help replace all the expiring debt30. This potential capital gap raises concerns that CRE values broadly could experience significantly more downward pressure30.
While economic downturns pose challenges, they also create opportunities for those who are prepared and able to adapt29. For example, during the COVID-19 pandemic, some investors were able to make what some experts consider a generational investment by acquiring distressed properties at significantly lower prices31.
Economic downturns present significant challenges for the CRE industry, but with careful planning and proactive strategies, businesses can mitigate risks and position themselves for long-term success. Understanding the historical impact of economic downturns, learning from past successes, and implementing robust business continuity plans are crucial for navigating these uncertain times. By staying informed about government support programs and expert opinions, CRE businesses can make informed decisions and adapt to the evolving economic landscape.
The research presented in this report highlights several key takeaways for CRE professionals:
|
Key Takeaway |
Supporting Snippet IDs |
|---|---|
|
Economic downturns can lead to decreased tenant demand, financial difficulties for CRE businesses, and declining property values. |
1 |
|
Historical data on CRE performance during past economic downturns, such as the 2008 financial crisis, provides valuable insights for understanding the potential impact of future downturns. |
2 |
|
Case studies of CRE businesses that successfully navigated past economic downturns, such as Xero and Mainfreight, offer valuable lessons for business continuity planning. |
12 |
|
Business continuity planning is essential for CRE businesses to mitigate the risks associated with economic downturns. |
22 |
|
Government support programs, such as EIDL, PPP, and economic adjustment assistance, can provide financial assistance and other resources to help CRE businesses during economic downturns. |
17 |
|
Expert opinions and forecasts suggest that the CRE industry may face continued challenges in the coming years due to factors such as elevated interest rates, high inflation, and shifts in how tenants occupy commercial space. |
1 |
|
Gains in 2025 for CRE depend on global interest rates. |
5 |
|
Asset vulnerabilities should be monitored due to the industry's movement toward smarter buildings. |
5 |
|
Digital economy properties are in high demand. |
5 |
Based on these findings, CRE professionals should consider the following recommendations:
By taking these proactive steps, CRE businesses can enhance their resilience to economic downturns and position themselves for continued success in the face of uncertainty.