Our economy operates in cycles, going through series of highs and lows with growth in between. While investors and the media often fixate on how this impacts the residential real estate market, these cycles can impact the commercial real estate market (CRE) in different ways and at different times. If you've ever wondered what exactly constitutes a commercial real estate crash, this article will dive into what factors impact and indicate a commercial real estate crash, as well as tips for how investors can not just identify but prepare their investment portfolio for a downturn.
Indicators of a commercial real estate crash
Indicators of a commercial real estate crash typically fall in line with most indicators used in economic and residential housing markets, such as an inverted yield curve or activity in the bond market, stock market, or financial markets. In the past, these economic indicators have been used to predict a recession, but the past few years have shown us that these indicators aren't always reliable predictors for a financial crisis.
Rather, it's certain aspects of the micro and macro commercial real estate market that ultimately determine if the market will crash. Like all real estate sectors, the CRE sector is locally influenced, meaning performance of each property type or the sector as a whole can be impacted negatively or positively, depending on what's happening on a localized level.
While certain aspects can be influenced by macro economic conditions or policies, what's happening in the local market often takes precedence over what may be happening globally. Beyond the local influence, each unique subsector is influenced by a number of different factors and is the reason each sector operates independently from others.
Factors that can cause commercial property to crash
Supply and demand is one of the most important factors to consider as it relates to the health of a market. An imbalance of this supply and demand can change conditions for commercial property values, cap rates, rental rates, vacancy rates, and performance on commercial loans.
Too much supply and not enough demand drives rent and commercial real estate prices down, while cap rates and vacancy rates slowly rise. Conversely, excess demand and limited supply results in higher rental rates and lowered cap rates and vacancy rates. Lowered income as a result of higher vacancy rates or lowered cash flow can make it challenging to make mortgage payments and can lead to an increase in commercial loan defaults.
Deflated economic activity and governmental policies can also impact the performance of commercial real estate. For example, some states and local municipalities mandated closures for businesses after the onset of COVID-19. This resulted in retail property, mall operators, hotels, and office space landlords and tenants being disproportionately affected.
Despite lulled economic activity and millions of Americans out of a job, industrial real estate continues to prosper. This scenario is the perfect illustration of how greater economic conditions can impact each property type uniquely.
Availability of financing also influences buying patterns. The cheaper it is to borrow money, i.e., the lower the interest rate, the more likely it is that buyers will flood the market and drive commercial real estate prices up. During challenging economic times, lending is often restricted, meaning it's harder to borrow money. This means there are less buyers on the market, and real estate values often decrease because of it.
Long-term trends also influence CRE performance. Over the past few decades, demand for retail space has slowly dwindled as the rise of e-commerce has changed how consumers buy and shop. This trend isn't going to reverse itself as technology continues to embed itself further into our day-to-day lives. This, among many other trends, are ones to watch, as they influence the ultimate supply and demand, both on a local and national level.
How to prepare as a commercial property owner
If you own commercial property and are trying to prepare or predict a commercial real estate crash, it's important to understand the local factors that may indicate or influence a crash.
First, look at local supply and demand in your immediate area. Consider the number of commercial buildings in development, planned development, and those completed. Then look at the vacancy rates and occupancy levels. High vacancy rates indicate there's oversupply for this asset class in the given market and lowered demand. Also, keep an eye on current trends to see how they might impact long-term supply or demand.
Maintaining low debt-to-income ratios means you are more likely to be able to maintain the investment during challenging economic times, especially if a tenant stops paying rent because of economic conditions. Overleveraging yourself means you may be forced to sell in a down market, receiving less for the sale or being met with a difficult time selling because of decreased demand.
The Millionacres bottom line
Crashes can happen (the Great Recession is a good example of that) but crashes often happen slowly over a period of several years, not all at once or overnight. This is why it's important for investors to monitor indicators that could lead to the market turning one way or another and following long-term trends that support the growth of a given sector despite outlying economic factors.