Commercial real estate is enjoying an epic run with prices approaching and in some cases surpassing pre-recession highs, new supply coming online at a controlled pace, and rental rates growing at about twice the rate of core inflation (which excludes food and energy). With the economic recovery having just begun its seventh year, some in the industry are wondering how much longer this can last.
The run of good fortune for commercial real estate will end when the next recession begins. Unfortunately, economists do not have a strong track record of forecasting recessions. In December, 2007—the month that the Great Recession began—only 38% of economists surveyed by The Wall Street Journal expected a near-term recession.
Recessions have four triggers:
Rising inflation: The classic cause of a recession is when the Federal Reserve “takes away the punch bowl” to combat rising inflation, meaning that the Federal Open Market Committee (FOMC) raises short-term interest rates to prevent the economy from overheating. Sometimes the Fed overshoots the mark, sending the economy into a recession.
Poor investment decisions: Cheap money and the herd mentality can cloud investors’ judgment, creating big losses for borrowers and lenders if their bets don’t pan out. Enough poor investment decisions can turn into a bubble, which, when it bursts, creates messy complications for the economy. Poor investment decisions caused, at least in part, the last three recessions: savings and loans made imprudent investments in commercial real estate, triggering the 1990-91 recession; the bursting of the dot-com bubble triggered the 2001 recession; and subprime mortgages triggered the Great Recession from 2007-2009.
Exogenous events: These are shocks to the economy from outside events. The first Gulf War was viewed as a contributing factor to the 1990-91 recession. Nine-eleven, at the time, was expected to trigger a recession, but based on data released later by the National Bureau of Economic Research, the economy was already in recession and was within two months of starting a new expansion cycle.
Loss of confidence: Consumer spending accounts for 68% of GDP, and business capital spending accounts for 16%. Anything that leads to a loss of confidence, including the three triggers listed above, can trigger a recession.
Where are we now? Inflation is not an issue in the U.S. The Federal Reserve is watching the financial markets, including commercial real estate, for potential bubbles caused by the extended period of low interest rates. Some analysts have feared that exogenous events such as Greece or Ukraine could trigger another round of financial instability, which could trigger a recession, but so far, it hasn’t happened. Lastly, consumer and business confidence are consistent with moderate economic growth. In summary, there is nothing to suggest a recession is imminent in the next 12 to 18 months.