High Interest Rates, Inflation, and Recession: Where Is the Real Estate Market Headed in 2023?

The 2023 real estate market faces a triple threat: recession, inflation, and high interest rates. While recession and inflation might be temporary, real estate investors are just beginning to understand the long-term ramifications of higher interest rates, and the whole picture should become more apparent in 2023. Here are a few things we expect to see, based in part on this article in the latest Preqin real estate report.

Hedging against inflation

Inflation typically drives up the value of hard assets and enables rents to grow faster than operating expenses, creating the proverbial “hedge” against inflation. But higher interest rates can upset this strategy if rising debt costs suck up the additional cash flow from higher rents. Despite the uncertainty, real estate ownership will still be an effective hedge against inflation for well-managed properties in the right markets in 2023.

Multifamily and industrial sectors continue to outperform

The industrial and multifamily sectors have outperformed other property types during the past few years and most likely will continue to do so into 2023. Mortgage rates more than doubled in 2022, leaving many Americans unable to afford a home and maintaining the demand for rental properties. The need for last-mile delivery and enhanced supply chains is continuing to boost the demand for warehouse-distribution facilities. In addition, hotels are thriving as vacations and group meetings have resumed, and the retail sector has benefited from an influx of in-store shopping. But a recession could soften hotel and retail demand.

Unlike other property sectors, office fundamentals continue to suffer. While we have seen many employers encouraging a return to work at the office, the rise in hybrid workforce arrangements is here to stay, substantially reducing the demand for office space.

ESG is a top priority

The real estate industry is responsible for about a third of all greenhouse gas emissions and 40% of global energy use, leading real estate firms to respond by reducing water and fuel consumption and managing waste more efficiently, ultimately helping them control costs. Real estate investors are also becoming increasingly focused on the vulnerability of their properties to severe climate conditions, both to reinforce the physical structures and to manage the rising cost of insurance.

Public real estate investment trusts (REITs) have played a significant role in developing and reporting on ESG initiatives. There’s an incentive for their bottom line to do so: ESG-focused real estate firms that offer environmentally friendly spaces with a focus on wellness and safety attract more tenants. Property owners will continue to focus on ESG in 2023 and beyond, integrating ESG principles into their real estate investments and operating processes.

Bracing for an unpredictable 2023 real estate market

We’re entering a new market-based interest rate regime that will significantly impact the real estate industry. The Fed artificially reduced interest rates after the Great Recession, and rates are now reverting to historical norms. The result is a volatile market with investors experiencing reduced expected returns on existing deals and a hindered ability to project cash flow accurately on new deals. On the bright side, the tight labor market will help sustain demand for space against a fixed supply, despite a recession. While the transition may be painful for some real estate investors, we can expect more predictability in the market as we settle into the new normal of 2023.

For more information, please visit Preqin’s homepage for the 2023 Global Real Estate Report here.