If the nation slides into a recession this year, commercial real estate investors could see their annual returns shrink slightly or plummet into negative territory, depending on property type and the severity of the economic storm, according to Property & Portfolio Research.

Apartment owners are better positioned to hold the value of their real estate holdings through a mild recession than owners of office, warehouse or retail properties, but will likely experience a greater drop in net operating income (NOI), says Hans Nordby, PPR’s director of U.S. market research.

“What benefits apartments [in a recession] are that everybody believes in apartments as a good port in a capital storm,” Nordby says. “While the NOIs on apartments have a lot of volatility in a recession, the cap rates are well-supported by investors.”

For office, warehouse and retail properties, net operating income often continues to improve through a mild recession due to lease terms that average about five years for those property types. Even if a landlord has to lower the asking rent on a property, tenants renewing a lease will still end up paying more than they had been paying over the course of a lease term that is rolling over. NOI, therefore, remains positive. Not so for apartments, where leases are renewed each year at market rates and the effects of recession are more immediate.

Investors tend to favor apartments as a safer investment than office, warehouse or retail, however, so those properties become less attractive during mild recessions despite their stronger NOI growth, Nordby says. As a consequence, investors buying those properties demand a greater initial return on their purchase. That means cap rates on office, warehouse and retail would increase in a recession, but perhaps not by much. The falling benchmark interest rates that usually come with a recession give buyers a better spread over cap rates without a severe increase in overall cap rates.
 
Differences in annual returns by property type in either a mild or severe recession are the subject of alternative forecast scenarios PPR has prepared for its clients. To be clear, the company’s baseline forecast still calls for slow economic growth in 2008 without a recession, which is defined as two or more quarters of negative GDP. In response to client requests, however, PPR reran its models to see what returns would likely be under more dire conditions.

Retail is the only one of the four major property types that would drop into negative annual returns in the event of a mild recession. That model shows retail entering negative return territory this summer, dipping to a 2% loss for 2008 and gradually recovering to positive returns in 2009. Every property type would suffer negative returns in the event of a severe recession, but retail would bounce hardest with annualized losses of nearly 6% in the summer of 2009, recovering with break-even returns in the summer of 2011.