With the onset of COVID-19 crisis in early 2020, economic conditions have turned from weak in 2019 to potentially quite adverse, characterised by abrupt disruptions to supply channels and weakening consumer demand. With the prospect of an imminent economic downturn, a key focus is on understanding the economic fallout on specific industries and more broadly on the labour market with consequences on unemployment. The outlook on the unemployment rate appears bleak, with increases ranging from seven percent to over ten percent, depending on the nature of the downturn. Importantly, how will a higher unemployment rate impact the commercial property market?
The unemployment rate cycle
A review of the historical profile of the unemployment rate shows that it usually rises rapidly during downturns, but falls slowly during the recovery phase. This is evident in the chart on the right which highlights the various downturns in the economy since the late 1970s. Both the recessions of 1982-83 and 1990-91 were quite severe and caused the unemployment rate to increase rapidly. In comparison, the downturns associated with the tech wreck and global financial crisis (GFC) were much more moderate; arguably, outcomes associated with effective inflation targeting.
A feature of these cycles is the duration; the time period between trough to peak (downturn duration) and subsequently, from peak to recovery (recovery duration). The larger the rise in the unemployment rate, the longer the time period to reach recovery. This idea of cycle duration is highlighted in Figure 2 which shows that the last two recession episodes had much longer recovery durations for the labour market than those experienced by the tech wreck and GFC. For instance, for the 1990-91 recession, the recovery duration was about 2.5 times longer than the downturn duration (38 months). In contrast, the GFC cycle experienced a shorter duration: a 11-month downturn duration and a 19-month recovery duration. While these cycle profiles have been partly influenced by the evolving structure of the labour market, economic policy has also played a role. Indeed, the relatively shorter duration associated with the GFC can be attributed to the combination of expansionary monetary policy and fiscal stimulus. Current government policy initiatives (i.e., fiscal stimulus including JobKeeper) are intended to minimise the rise in the unemployment rate and ensure a shorter duration profile.
The labour market and commercial property market
The labour market is a key demand driver of the commercial property market. While links between these two markets are commonly examined via employment growth, our focus is on the unemployment rate. Figure 3 clearly depicts an inverse relationship between the unemployment rate and office property sector vacancy rate. During the 1990-91 recession, the downturn in the labour market saw the office vacancy rate rise quickly towards 20%. This was ultimately reflected in declining rents and falling asset prices. With the later downturns, rises in the vacancy rate were more moderate, in line with modest rises in the unemployment rate. Despite this, it’s worth noting that during the GFC, the fallout on commercial property markets was significant with capitalisation rates softening, on average, by 100 basis points.
Over the short-term, the current downturn in macroeconomic activity and weakening labour market will undoubtedly translate into sluggish demand for space and rising vacancy, lower rents and retreating asset prices. However, what is of greater interest is the nature of the downturn and its pass-through effects on the property market and across its key sectors.
Property market scenarios
With uncertainty surrounding the economic outlook, we consider three property market scenarios that are likely to represent the range of possible outcomes. These are referred to as soft-landing, moderate weakening and protracted downturn. These scenarios take into account key risk factors associated with the macroeconomy, capital market conditions and virus containment.
In the soft-landing scenario, while no vaccine is immediately available, the virus is somewhat contained with an easing of lockdown measures. Supported by the strong fiscal stimulus, the economy faces recession but rebounds quickly and the unemployment rate rises mildly towards six percent, suggesting a V-shaped recovery. This is likely to lead to mild rise in space vacancies, muted falls in rents and a slight softening in capitalisation rates across selected property sectors.
In the moderate weakening scenario, no vaccine is foreseeable within the year and the country faces sporadic virus outbreaks. The economy experiences recession with a slow rebound and a moderate rise in the unemployment rate towards eight percent, suggesting a U-shaped recovery with duration of around five years. Investment market activity remains cautious. This is likely to result in a slightly wider disconnect in space market fundamentals than that experienced during the GFC which will generally translate into higher vacancies, with falls in effective rentals and asset prices varying across property sectors.
In the protracted downturn scenario, virus contagion continues to spread with a vaccine still a long way off. The economy experiences significant contraction and an unemployment rate around ten percent, suggesting a prolonged U-shaped recovery with duration of about seven years. Investment markets factor in a lower economic growth trajectory for the short to medium-term outlook. This is likely to lead to a steep rise in vacancies, declines in rents and asset prices across all sectors but also a persistent divergence in space market fundamentals that will see a longer recovery period.
While the commercial property market is likely to experience a downturn, the nature of this downturn remains variable, contingent on many factors including the state of the labour market and the play-out of the virus.