Preparing for a Cooling Economy
Leverage your real estate portfolio for an eventual downturn in the market.
Although the sting of 2008 may not register for some of today's workforce, many clearly recall the excesses leading up to the Great Recession. To mitigate risk related to a corporate real estate portfolio, leaders must identify shifts in economic conditions and deliver spaces (and experiences) that appeal to tenants and their employees.
As David Shulman, UCLA's senior economist, notes in his article, “The Goldilocks Economy,” an inflection point exists that is neither too hot nor too cold, where inflation and recession seem to be in check. Before recession looms, however, it's important to outline a long-range, scenario-based planning and investment strategy for commercial real estate to provide for the best and worst of times.
5 Ideas for Planning Ahead
1. Look at the balance sheet. The healthier a business, the more resilient it will be in a downturn. Could an economic downturn present an opportunity to invest in people, spaces, or technology related to operational efficiencies and employee effectiveness? Yes. Understanding long-term organizational objectives (cost-cutting and growth strategies, for example) will help CRE professionals advise investors or clients in decision-making.
2. Follow emerging trends. A joint publication by the Urban Land Institute and PwC identified that the market is sensing a slowdown in the real estate marketplace in 2020. The reason? Rising costs for land, financing, and construction. Office development and investment prospects ranked toward the bottom of the six property types. The demand for more logistics (warehouse) space is one outlier, thanks to the Amazon effect.
3. Keep an eye on construction costs. Many general contractors report business in specific growth markets is robust, with a backlog of projects stretching into 2023. That backlog helps drive prices for real estate because contractors can be more selective about bidding on projects. The primary challenge, however, still revolves around skilled labor and project management.
“The next three years look really bright,” says Jon Dandurand, vice president of JE Dunn Construction, based in Kansas City, Mo. “We're finally starting to see technology catch up with outdated means and methods in construction. Even with a downturn, the war for talent will only continue, meaning the investments corporations make in their real estate will be that much more important.”
4. Assess the rental marketplace. “Rental markets have remained strong as rate increases persist,” explains Renae Bradshaw, vice president for tenant representation at JLL. “To incentivize tenants, landlords are offering richer concessions in abatement and tenant improvement capital. Last year's 12 percent increase in construction costs also provided a challenge to tenants. We are helping tenants approach the market differently today, focusing on how to build flexible space for growth, without adding square footage. We continue to structure leases with options to respond to business drivers over the life of their lease.”
5. Recognize real estate is an unavoidable and somewhat fixed capital expense. Current economic conditions are ideal for conducting a full-scale evaluation of real estate assets. The technology sector has evolved to the point where data collection, synthesis, and application have provided a strategic advantage for tenants.
Pay Attention to Economic Cycles
Historically, when the market experiences a slowdown, corporations quickly reach for options to help maintain profitability and shareholder confidence. What areas are hit? Research and development? Marketing and advertising? Layoffs might provide a quick fix, but how does that impact an organization's overall morale? “I'm witnessing a large investment in activities and amenities that drive corporate culture,” says Vik Bangia, CEO of VERUM Consulting in Minneapolis. “Clients who demonstrate a concerted effort to foster their corporate culture are experiencing the greatest growth and will be in better competitive position to weather any pending economic storm.”
With today's low unemployment rate, some say the war for talent is driving the need for increased employee engagement and amenity-rich spaces. Flexible space can help companies remain light on their feet as employee populations fluctuate.
Rolling the Dice Is Not a Strategy
Because no two recessions are exactly alike, how might a downturn affect your portfolio? What are some steps a commercial real estate professional might consider doing now?
- Partner with a company's financial team to understand the market outlook and impact on the business (cash flow, credit rating, etc.).
- Create an enterprise plan that spans your portfolio.
- Identify immediate, midterm, and long-term opportunities to optimize the portfolio.
- Develop three to five planning scenarios for various market conditions (hot, warm, and cold).
- Identify tactics for each condition.
- Balance strategic scenario planning against the human/cultural side of things.
Everything begins and ends with customers (both internal and external). When the market contracts, customer behavior shifts - in terms of confidence, lacking funds, shifting priorities, and other factors - and strong businesses acknowledge that the game has fundamentally changed.
While it may seem incongruous to plan for the worst when times are good, the best CRE professionals will. They will be in tune to their lines of business and understand how the work, the worker, and the workplace may change. They look at how to adapt spaces if a tenant or part of their organization moves out, and they know how long the investment can be carried if a downturn becomes extended.
You do not have to be a trained economist, but you need to understand and act when it comes to up and down cycles. As a result, you'll be able to create a more well thought-out commercial real estate investment strategy.
Start the conversation on planning for the worst, even if you remain bullish about the investment market.