Impact of looming economic downturn on commercial real estate sector debated

Dark clouds are gathering on the horizon in the form of rising gas prices, continued supply-chain and logistics issues, construction material shortages, geopolitical forces and the continued hangover of the COVID-19 healthcare crisis, prompting speculation of a looming recession. During down economic cycles, commercial real estate is typically regarded as safe haven for the investment of financial resources and an excellent hedge against inflation.

With some sentiment that real estate may also be caught in the down draft, what are the expectations for the Maryland real estate industry? Offering their insights and perspectives concerning the possible exposure and risks on real estate during a widespread economic slowdown are Seema Iyer, Associate Director, Jacob France Institute at the University of Baltimore and Owen Rouse, Vice President of Investment Sales, MacKenzie Commercial Real Estate Services.

The perfect storm: inflation, ground war and pandemic

Owen Rouse (OR) – The economy is dealing with the highest inflation in 40 years, the first ground war in 75 years and the lingering effects of the healthcare crisis. Any one of those three are enough to cause harm to the economy and consumer confidence, but the confluence of these negative factors has created serious challenges across the board. Did I mention higher interest rates as well? Supply chain issues have thrown a wrench into scheduling and escalated material costs and soon, a pinch point will emerge for construction management companies. With labor also an issue, general contractors are providing project estimates but only holding prices for 10 days given all the turbulence. Want some more bad news? The thing that businesses hate most is uncertainty, which causes delays in real estate decision-making and typically translates to a conservative, wait-and-see approach. At this point, the commercial real estate industry seems to be weathering the storm in the Maryland region, with much of the price increases already baked into projections. We are certainly in an extremely unique and dynamic market, and it will take more time to see how things unfold.

Seema Iyer (SI) – Skyrocketing residential prices have actually been a good thing for under-valued neighborhoods such as the 21229 zip code, which has emerged as among the hottest residential markets in Baltimore City. The market in general has been severely overheated with bidding wars breaking out for houses at all price points, but we see that now changing with mortgage rates on the rise. The buying frenzy swung into neighborhoods that experienced very little activity over the past several of years and that has been encouraging. We are not quite sure which way the market is headed at this point given all the turmoil. Rising prices and shipping delays have forced construction managers to become extremely creative with value substitution and value engineering, with significant escalations during the construction process. A local homebuilder was informed about a major increase in roof trusses costs and they felt compelled to immediately make the purchase and rent a parking lot to store the materials.

Infrastructure spending and resilient retail

OR – Maryland remains in the halo of the capital of the free world, which is not a bad place to be, and real estate typically behaves differently than in other parts of country. We are somewhat insulated, mainly due to the tentacles of the federal government, which makes our highs not as high, and our lows not as low as other markets. Consistency is good. I do worry about a bit about commodity office buildings, with companies right-sizing to address work-from-home and hybrid work models, particularly those in generic locations. Retail, in turn, remains as resilient as ever and has largely rebounded from the pandemic. When restaurants go out of business, we typically have two or three concepts waiting in the wings for the spot, with the allure of in-place equipment and better rents. There is no shortage of second-generation tenants ready to take vacant spaces.

SI – Rising home prices have created more apartment renters and the multifamily sector continues to go gangbusters, although a housing shortage remains. The American Jobs Plan designed to improve our country’s infrastructure bill will assure that construction will not slow in the Maryland area, and we have been presented with an opportunity to dramatically improve the local transportation infrastructure, while also improving our water and air systems. While all real estate asset classes would benefit from better transit, residential and workforce housing would specifically benefit. Baltimore City recently created an Office of Infrastructure Development and named a czar to coordinate major capital projects and maximize the receipt of federal funds for construction projects. Concerning retail, I do wonder about the long-term viability of small retailers and am not sure if traditional Main Street corridors have come all the way back.

Industrial sector seems unstoppable 

OR – Despite all the predicted doom and gloom spurred by rising interest rates, industrial buildings are still trading at aggressive numbers, especially the single-tenant variety. Potential sellers look around and say if that seller received that price, I must be able to get twice that figure. But available buildings are becoming harder to come by, especially in Baltimore City and, soon, companies might not have a place to go. Another eye-opening occurrence has been the rapidity of rent increases, in some cases a 100 percent escalation. With all the recent talk about Amazon scaling back its warehouse requirements, they still have accounted for only two percent of all Class “A” space in the past decade. This will enable other companies to play catch up on logistic chains, and there is no shortage of major industrial/warehouse projects currently in the Maryland area.

Baltimore City office market remains a concern

SI – Baltimore City’s vacancy rate in the central business district has risen to approximately 21 percent, and there still remains the potential for cannibalism. The Pratt Street corridor is a major concern, in particular. The possible bright news is the recent merger of the City’s two top economic development groups and the hope is, with a singular focus and vision, they can make inroads into attracting new companies downtown. Many cities are struggling across the country, but although Baltimore has many challenges, we have shown the ability to persevere and arrive at solutions.

OR – The ongoing migration of companies to the East side is concerning and T. Rowe Price is about to create the biggest hole ever on Pratt Street. Organic growth is hard to come by in Baltimore.  Companies are establishing hub-and-spoke models with new locations in the suburbs and, together with WFH trends, this is further emptying out cities. There seems to be a groundswell of support for return-to-work guidelines and I am betting on local leaders speaking with a single voice will be heard. Baltimore has much to offer with a fundamentally sturdy base which augurs for the future.