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The commercial property sector has an important role to play in the UK economy, not only in terms of a direct and indirect output generator, but also in terms of helping retailers, financial services and other businesses boost production.
But what if the UK economy were hit by a recession? Will the commercial sector continue to thrive?
If you think back to the summer of 2007, a large number of commercial property investors, were searching for property that would provide at least an above average return-on- investment. Property values were on the rise, and they wanted in on the action.
However, what they were unaware of was, that they would be investing in property on the verge of a 6-year bull market. Sure enough, by December 2007, the Great Recession had built enough momentum to induce the property market into an irrecoverable nosedive.
Well, it happened again in March 2020 after, ironically, a persistent 10-year ‘up-seller’s market’. Things went from bad to worse when the pandemic shook up the world, and it seemed that property investors, buyers, sellers, and lenders had forgotten that a recession was still a ‘thing’.
So, what happens to commercial property when a recession hits?
Commercial property values are not affected the same way as residential property during a recession. Residential values tend to react to an abundant housing supply and lacklustre demand. As homeowners are deprived of their usual incomes, they fall behind on mortgage payments, which means that too many houses end up on the ‘for sale’ market, along with too many properties being sold at reduced prices.
On the other hand, commercial property values play out differently because they are primarily based on NOI or ‘net operating income’ – this is made up of rental income and expenses. In the midst of a recession, most commercial properties see reduced occupancy, and late payments. Furthermore, no amount of paying tenants can help lower NOI. This actually reduces the income approach in a commercial appraisal, hence, lowering the property’s value.
Commercial property outlook in a recession scenario
It’s probably safe to say that the chances of a coronavirus-induced recession occurring again are probably 1-in-100 years. But typically, recessions occur when businesses expand at unusually (and unreasonably) high rates, which leads to a correction in all financial markets.
In order to avoid purchasing commercial property at the top of the market and overpaying for it, one must identify the real estate market cycle phase they are in – the recession phase, recovery phase, expansion phase, and so on – all the while making sure that there is extra NOI to get through a recession and maintain the property’s value.
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