CRE on the Chopping Block Among Companies Worried About Inflation

Article originally posted on Globe St. on August 4, 2022

Inflation and recession worries are pushing executives to plan preemptive cutbacks.

There are economists who insist that the US is not yet in a recession and economists who say it is, or at least will be soon. Business executives can’t delay their actions for the final ref’s call, so they’re making plans, many of which involve cutting expenses, including real estate.

JLL chief economist Ryan Severino in a note recently said, “the evidence we have thus far of a recession seems rather flimsy” with data that “remains ambiguous and unconvincing” for a number of reasons, like the influence of slower exports in Q1 and the expansion of gross domestic income (GDI), which should correlate to GDP. And given the margin of error in the calculations, “there is a roughly 50% chance the economy actually grew in the first half of the year.”

Still, there is significant unease in the corporate world, perhaps due to the need for risk management. The Conference Board’s measure of CEO confidence for the second quarter of 2022 was 42, down from 57 in Q1. As the group noted, “The Measure has fallen into negative territory and is at levels not seen since the onset of the pandemic. (A reading below 50 points reflects more negative than positive responses.)”

About 60% of CEOs did think that the Federal Reserve’s actions would tame inflation “over the next few years” but at the price of a “very brief, mild recession.”

“CEO confidence weakened further in the second quarter, as executives contended with rising prices and supply chain challenges, which the war in Ukraine and renewed COVID restrictions in China exacerbated,” said Dana M. Peterson, chief economist of The Conference Board. “Expectations for future conditions were also bleak, with 60 percent of executives anticipating the economy will worsen over the next six months—a marked rise from the 23 percent who held that view last quarter.” Moreover, the tight labor market has pushed 70% of CEOs into increasing wages.

So, with concerns about the coming economic climate and expectations among 63% of CFOs that Gartner polled of inflation lasting at least another 12 months, it isn’t surprising that many companies will be cutting a more cautious course. According to the firm, the strategy of companies so far has been to pass along cost increases to customers by raising prices. But in the back half of the year, double the usual number of companies will be cutting costs because when demand starts to drop, as would be expected during inflation, the ability to raise prices falls away, Alexander Bant, chief of research for CFOs at Gartner, explained in a podcast. CFOs indicated that they would start looking at functions differently and how they spend there, with real estate being one explicitly mentioned.

The Wall Street Journal quoted Bant as saying that 45% of businesses planned real estate reductions. It’s important to remember that reductions to a CFO could mean dropping unneeded space, slowing planned additions, or using strategies like sale leasebacks to pull in cash influxes as a form of financing.

And a Reuters analysis of recent quarterly earnings reports “revealed more than 25 large companies plan to reduce their office space in the year ahead, a move designed to reduce the second-largest expense after payrolls at corporations.”

Additionally, companies are looking hard at their supply chains to separately control costs, according to Paul Lord, senior director analyst with the Gartner Supply Chain practice. “For example, higher material prices and interest rates dramatically increase the cost of discretionary inventory,” he said. “This might result in a change to smaller production quantities for better balance between capacity and working capital economics. If there is concern about a looming recession that would result in significant stock devaluation, the higher cost of faster transportation modes may be justified in some cases.”

The use of industrial space could move in different ways, depending on the decisions. A company might go for lower amounts of inventory, reducing space needs, or they might look to even adding some space in different areas to stock more efficiently and reduce transportation costs, which have been high.

CRE professionals will need to watch trends carefully and maintain as much flexibility as possible to respond.

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