As we move through January 2024, it looks like the U.S. economy is on a path towards recession. This is no longer in the realm of speculation; the signs are becoming more pronounced. For those of us in the commercial real estate sector, grasping the implications of this trend early will help us navigate the challenges ahead.

Let's start with the big picture. The yield curve, particularly the 10-year/3-month Treasury yield spread, is behaving in a way that historically signals a recession is imminent. This curve has started to de-invert, a change that usually happens just a few months before the economy takes a downturn. The market is essentially telling us to brace for slower growth. The Fed’s interest rate decisions, while aimed at keeping inflation in check, have the side effect of putting the brakes on spending and investment.

The impact on commercial real estate will be mostly negative. Office space may see even more reduced demand due to cost-cutting by tenants. Retail faces risks with increasing consumer debt, but strong fundamentals could provide some resilience. The industrial sector may experience slowed demand but likely without significant rent drops, while the multifamily sector is encountering supply issues, though a major downturn seems unlikely.

Although there's no real bright side, it's worth noting that alternative sectors like healthcare, data centers, and logistics will likely be more stable. These property types have unique strengths that should keep them better insulated from the recessionary pressures. And the scarcity of top-tier office space in some cities could soften the blow a bit for Class A properties.

As for distressed assets, there will likely be an uptick, especially in lower-quality office assets. But many properties have strong net operating incomes, which should help cushion the impact. We expect things might get a bit tighter in capital markets and lending, but if the Fed pivots in the latter half of 2024, it could bring some much-needed stability to the financing environment.

Whether the Fed pivots or not may depend partly on the personal consumption expenditures (PCE) inflation rate moving towards the Fed's 2% target. Even if the labor market weakens, the Fed won't budge without this improvement. Wage growth needs to slow to a more manageable level. So, while consumer price index (CPI) inflation is heading in the right direction and the job market is cooling, high wage growth, currently around 5%, needs to be reduced to about 3.5% to stabilize inflation.

Kevin Thorpe, the lead economist at Cushman & Wakefield, recently shared his thoughts on how the real estate sector could start seeing some improvements: "The link to commercial real estate kind of goes like this, slower wage growth leads to sustainably lower inflation, which leads to interest rate stabilization, which leads to cap rate stabilization, which ultimately leads to increased transaction volumes."

The market is clearly bracing for further difficulties this year, with each sector feeling the effects differently, none positively. The office and retail sectors will encounter tough conditions, while the industrial, multifamily, and alternative sectors are likely to show more stability. The behavior of capital markets and the direction of distressed assets will be important factors to watch. We will also pay close attention to inflation and wage growth, as these will be the first indicators of a rebound in commercial real estate.

🦠 Contagion: The re-insurance giant Swiss Re has forecasted that China’s developing real estate crisis will most likely not spread to the rest of the economy thanks to the nature of the property sector’s debt and government efforts to manage deleveraging.

⚖️ Tax bias: The New York State Supreme Court will be brought by a coalition of real estate developers, civil rights groups, and homeowners alleging the tax system unlawfully discriminates against New Yorkers of color while favoring wealthy, white residents.