The commercial real estate (CRE) market is always changing, and this is even more pronounced during times of economic recession. Though we are not currently in a confirmed recession, we have experienced recessionary turmoil in the last 18 months and will likely do so throughout 2023.
This instability makes trusting in CRE investing difficult. However, there is still one type of real estate you can count on to not only provide reliable, increasing income, but also steady returns that aren’t subject to geopolitical strain and economic uncertainty. But first, let’s review the CRE investments to avoid in 2023, since knowing what not to buy is just as important as knowing what to purchase.
CRE to Avoid in 2023: Office Space
Since the pandemic, work-from-home (WFH) has created large-scale office sector vacancies. As of December 2022, vacancies were up over 16% compared to the same period in 2021. Rather than vacate, many tenants continue to lease but have difficulty paying rent due to financial insecurity.
Many office-space tenants — even some major companies — have sold their large buildings and downsized, renting smaller, converted offices and coworking spaces. This trend is reflected in the 15% decrease in the average demand for office space per employee (from 2019) and the increased competition for newly designed spaces while older, less functional office spaces sit empty.
Additionally, landlords are being forced to negotiate lower prices and better lease terms while spending capital on renovations, upgrades, and next-level amenities. They are working hard to outshine the competition and meet office workers’ new standards to attract quality tenants. This can get costly. Some examples include:
- Offering tenant improvement allowances.
- Adding the latest in-office technologies (smart devices, cameras, security, high-speed broadband, large projection screens, etc.).
- Upgrading with amenities that make the commute worthwhile, such as full kitchens, lounge areas, separate working areas, phone rooms, etc.
- Installing electronic vehicle (EV) charging stations.
- Keeping up with a high level of maintenance and ongoing management of the property.
For all these reasons and the high-risk nature of these properties, we recommend being very cautious or completely avoiding investing in an office building in 2023.
CRE to Avoid in 2023: Multifamily
Multifamily real estate had one of its best years ever in 2021-2022. Apartment complexes were built at lightning speed and those who could not afford homes were moving in as fast as possible. Now, renters have so many choices, they’re not renewing their leases but going where rent is cheapest. Also, major tech company and non-service-industry layoffs continue, leaving would-be renters in a bind — they can’t afford to buy a home or move into a high-cost apartment or condo complex so they’re living with friends or family. According to a report published in a Globest.com article, “2023 could be the year landlords compete for renters. There are currently more multifamily units under construction than at any point since 1970.”
You’ll find owners of multifamily properties being forced to sell due to loan maturation and they don’t want to refinance at higher interest rates. Apartment buildings typically offer attractive cap rates of 10.00–12.00%, sometimes even a little higher, but when you factor in …
- taxes, insurance, property management fees and salaries
- operational costs, building maintenance, and common area maintenance expenses
- tenant turnover and rent-payment delinquencies
- the fluctuating costs of goods and services
- an unpredictable vacancy rate
- and any unforeseen or underestimated costs
… the pro-rata share of estimated expenses paid by your tenants becomes less than what you’re actually paying. In the end, that 10.00–12.00% cap rate can become a 5–8% internal rate of return (IRR) or less, with lost time, frustration, and real estate management that chips away at your freedom.
You may find a multifamily complex for sale that looks like a great deal on paper, but unless you can pay all cash and have significant working capital to manage and maintain the property, it’s best to avoid this type of high-risk investment.
The share of apartment tenants who renewed leases declined in January to 52%, the lowest level for that month since 2018, according to property-management software company RealPage. – WSJ
CRE to Avoid in 2023: Full-Service Restaurants
Full-service dining has not quite rebounded to post-pandemic levels. One major contributor is that while full-service restaurants were shut down, the fast-food and quick-service market catapulted forward with smart technology, expanded drive-thrus, and curbside and online delivery. Consumers are used to these on-demand services, making it less appealing to take the time and spend the extra money to dine in. A recent study shows drive-thru business is up 13% and delivery is up 11.5% above pre-COVID levels.
Unfortunately, according to Restaurant Business, “Only 16% of the nation’s [full-service] restaurants expect profits to increase in 2023, with 50% bracing to make less money than they did last year because of soaring [energy, labor, and goods and services] expenses.” Though it is not all doom-and-gloom for full-service dining as many restaurant chains have adapted and are doing better, there is and always has been a higher inherent risk of owning this type of property.
Risks of full-service restaurant real estate investments:
- Considerable risk of vacancy.
- Rental payment delinquencies or abatements.
- Large capital outlay to upgrade and/or maintain the property to food-service standards.
- Ongoing building and common area maintenance expenses.
- Taxes, insurance, and property management fees.
- Unforeseen and/or underestimated costs.
- Depending on the location, the possibility of not re-tenanting the property for a long time.
- Potential remodeling or rebuilding costs when the tenant vacates to make it appealing to other types of tenants.
Jason Simons, VP of Westwood Net Lease Advisors, explains, “Even in the best of times, office tenants, multitenant and multifamily properties, and full-service restaurants can be particularly costly, unpredictable, risky investments. Currently, they are susceptible to corporate downsizing, the work-from-home trend, consumer spending fluctuations, labor uncertainties, and the inflated cost of utilities, which is why we don’t recommend clients invest in them in 2023 unless there are extenuating circumstances.”
A single-tenant, major-brand triple net (NNN or net-net-net) lease property is one of the lowest-risk, income-producing investments you can make in any economy — even in a recession. Just about any NNN property will provide a predictable, often guaranteed income stream over a long period of time, something multitenant, full-service restaurant, and office space properties simply can’t match.
Essential retail stores, fast food and QSRs, child care centers, medical clinics, drug stores, and gas and convenience stores are resilient and adaptable, historically performing just as well in an economic downturn as they do in a thriving economy. The last few years have proven that most are pandemic-proof, internet-proof, and recession-proof.
The most valuable aspects of an absolute triple net investment are the:
- Valuable real estate, as tenants tend to build in prime locations.
- Long-term, corporate-guaranteed lease backed by a multibillion-dollar investment-grade company.
- Inflation-resistant nature, with periodic rent increases built into the 10-to-20-year lease.
- Market value that doesn’t fluctuate daily and offers reliable cash-on-cash returns.
- Hassle-free ownership, potentially offering decades of expense-free, reliable monthly income.
- The opportunity for a 7–10% internal rate of return (IRR).
- Rarity of vacancy or rent abatement issues.
- Lender appeal – it is much easier to obtain a mortgage with more favorable terms.
- The chance to shape the investment to your financial and lifestyle goals.
As with any investment, there is still a slight risk. For example, if obtaining a mortgage, make sure the rent received services the debt and leaves you with a solid financial plan going forward, so you don’t get into trouble not being able to make the mortgage payments. When it comes to landlord management and costs, there is no downside to triple net lease investing, unless you enjoy hands-on, day-to-day property management.
Single-tenant retail is the best CRE investment opportunity in 2023. Emerging from pandemic isolation, human-to-human interaction has become important again. Brick-and-mortar store sales have rebounded, and numerous triple net tenants continue to add locations and revamp older stores.
To Wrap it Up — Types of CRE Tenants to Avoid During a Recession
When investing in commercial real estate during an economic downturn or recession, it’s important to be selective about the types of properties and tenants in which you invest. Many CRE tenants, such as office space, multifamily, and full-service restaurants, are still being impacted by the adverse effects of the pandemic, supply chain woes, rising interest rates, inflation, and the labor market, making them high-risk investments. It’s best to avoid these tenants since they lack stability and predictability and their ability to pay rent may diminish as the economy slows down.
Conversely, major-brand NNN tenants offer secure cash flow for 10–20 years or more and the least amount of risk. Dollar stores, drug stores, auto parts stores, convenience stores, gas stations, child care centers, medical clinics, and fast-food outlets provide income and help you build wealth, even when times are tough. With proper research and planning before investing in CRE properties, you can protect your assets while reaping significant rewards over time.
NNN property sellers are negotiating prices down and cap rates up, lenders are offering competitive terms and special deals, and many triple net tenants are growing and adding locations. It is still safe and smart to triple net invest in a recessionary economy. Let us help!
Westwood Net Lease Advisors are here to help you make the wisest NNN investment for your risk tolerance, financial goals, and lifestyle factors, whether you’re new to CRE or a seasoned investor. Contact us today for a no-obligation conversation; our buyer representation is free. 314-997-5227