We’ve touted the benefits of investing in commercial real estate before—but is now really a good time to buy? Nearly 50% of Americans believe a recession could be on the horizon, and several experts agree. Then again, we’ve been hearing the same warning for several years without a significant course-correction. Indeed, the bull market could continue for several more years. It’s anyone’s guess.
So where does that leave you, as someone who wants to invest in commercial real estate? It’s important to remember that real estate moves in cycles. There will be ebbs and flows over time. That doesn’t mean you shouldn’t invest in real estate when the market is at a peak. It just means that you should take extra precautions before doing so.
At Trion Properties, we believe buying income property can be a wise decision regardless of where we are in any given market cycle. Savvy investors will develop a recession-proof real estate strategy that helps them weather even the worst market conditions. In this article, we take a look at how to build a recession-proof real estate portfolio at every point in the market cycle.
What is a Recession?
Technically, a recession is considered to be any period in which the national gross domestic product (GDP) growth rate is negative for two consecutive quarters or more. In laymen’s terms, a recession is when business activity, sales and revenue begin to contract. Businesses stop expanding and many employers stop hiring or even begin to lay people off.
When a recession occurs, or even when there’s speculation of a looming recession, a few things happen in the real estate market. Most areas shift from a seller’s market to a buyer’s market, as prices begin to soften. Lending becomes more stringent, which makes it harder for people to buy homes (and therefore, to sell homes).
Because the economy weakens, fewer people are relocating for new jobs and as a result, homeowners tend to stay in place longer. In the worst of cases, like we saw in the 2008-09 recession, home values collapse to the point where people become underwater on their mortgages. Unable to afford their mortgage payments (often as a result of job loss), some homeowners are forced into foreclosure with the banks taking title to the property.
It is very difficult to predict when a recession will hit. There are some indicators of an impending recession, such as an inverted yield curve, but there is no way to predict with certainty when a recession will hit – and moreover, how extreme the recession will be or how long it will last when it inevitably happens.
What Should a Recession-Proof Real Estate Strategy Include?
Recessions inevitably happen. It’s not a matter of if a recession will hit, but when. Some investors will become paralyzed with fear and as a result, not invest in real estate if they’re worried a recession is on the horizon. On the contrary, savvy investors will continue investing but will take several steps to recession-proof their real estate portfolio.
Protecting Your Portfolio
There are many ways a real estate investor can protect their portfolio. The first thing to do is maximize cash flow. Even if property values decline in the short-term, having strong cash flow will help investors weather any economic downturn. Increase rents to market rate if you haven’t done so already and identify any other low-cost ways to boost revenue (e.g., separately metering utilities or installing coin-operated laundry machines).
A second strategy is to reduce your debt load. Now is a good time to refinance into lower interest rates, if possible, and to pay down any oversized loan balances. This way, if a recession were to hit, you’ll have enough equity to weather a decline in values. Less debt will also help improve your cash flows.
Factoring Risk and Yield
In advance of a recession, many banks loosen their lending requirements and are willing to extend credit to borrowers at exceptionally low rates with high loan-to-value ratios. Whereas a bank might seek a 65- to 70-percent loan-to-value ratio during a recession, this can creep upwards of 90 percent or more in a bull market. As a result, some borrowers, in search of higher yields, become over-levered on high-risk deals. This is also when we start to see novice investors, especially first-time developers, take on projects that are beyond their capacity. When a recession hits, it’s these investors who tend to lose the most.
A savvy investor will always consider risk and yield when investing in advance of a recession. Keep your debt loads low and resist the temptation to invest in higher-risk, speculative deals. It is often worth paying a premium, even at the peak of a real estate cycle, for a property that has lower rates of return but is an otherwise “safer” investment.
We mentioned above that reducing your debt load is a good way to preserve your portfolio. A related strategy is to increase your overall liquidity. Real estate is an inherently illiquid asset class. You cannot buy and sell real estate as easily as you could, say, stocks – which can be traded with the click of a button. Recession-proof your portfolio by unloading underperforming assets in order to increase your liquidity. Having more cash on hand will make it easier for you to invest during a recession, when real estate prices go down and lending tightens.
Related, consider taking out a line of credit against any property where you have abundant equity. You may never need to tap this line of credit, but it will be worth having available to you during a recession, when credit becomes harder to come by.
Where to Invest Before a Recession
Real estate prices tend to be at their peak right before a real estate recession. As a result, many investors are priced out of primary markets like New York, San Francisco and Boston. Instead, they chase yield by going to secondary or tertiary markets, where real estate tends to be less expensive. But research indicates this can be a fool’s errand.
In fact, research out of MIT’s Center for Real Estate Development confirms what many investors have long believed to be true: the best way for investors to maximize their long-term returns is by investing in primary markets. During a recession, real estate in primary markets tends to hold its value better than real estate in secondary markets like Phoenix or Las Vegas. This is particularly true of multifamily and office real estate, as primary markets tend to be major employment centers and as such, workers will still need a place to live—even during a recession.
In other words, the study finds that investors are better off paying a premium for real estate in a primary market – even if that means they’re buying Class B or Class C buildings – than buying Class A properties at a discount elsewhere. These properties might take a hit during a recession, but they won’t be hit as hard given their premier location. They’ll also recover their value faster as the economy begins to improve. As the old real estate adage goes, “location, location, location!”
What to Invest in Before a Recession
Not all real estate is created equally. Some asset classes are considered “safer” than others (e.g., multifamily, office and increasingly, industrial). There are some asset classes (e.g., vacation rentals, hotels and retail) that are more heavily impacted by economic conditions. Here is a look at what to invest in (and what to avoid) in advance of a recession.
One way to safeguard your real estate portfolio is to diversify your holdings. Diversification can take many forms, including investing in multiple asset classes in multiple locations.
Another way to think about diversification is in terms of the investment vehicle. For example, you might want to invest in a syndication that is investing in ground-up development projects (medium- to high-risk). You might separately invest personally in a fund where you have automatic diversification and the sponsor’s promote is crossed against all of the assets in the fund. You might also invest in a real estate investment trust (REIT), shares of which can be bought and sold similarly to stocks and therefore, easily liquidated as needed.
Do Invest In
There’s no “foolproof” real estate investment, but there are some asset classes that are more prone to withstand economic variations than others. Multifamily is one such example. One of the reasons multifamily tends to outperform other asset classes, regardless of where we are in the real estate cycle, is because at the end of the day, everyone needs somewhere to live.
In fact, when the market softens and a recession takes hold, many homeowners lose their property to foreclosure and are forced back into the rental market. As such, even in a down market, demand for multifamily housing tends to remain strong. Multifamily values might not appreciate, and rent growth might slow, but multifamily investors who have positioned themselves well (e.g., not having taken on too much debt) will still fare well during a recession.
Another asset class to consider investing in prior to a recession is off-campus student housing. Leading up to a recession, investors might have to pay a premium for student housing—but student housing tends to be relatively shatter-proof even when the economy declines. Year after year, students will continue to enroll in college and university. In fact, many will choose to go back to school for an advanced degree during a recession as a way to further their economic prospects upon graduation.
Avoid Investing In
Vacation homes, hotels, retail and speculative investments are all best to be avoided in advance of a recession. Demand for vacation homes and hotels tends to winnow during a recession. People vacation less during a recession, and those who do will tend to stay closer to home than traveling to faraway or exotic locations. The same is true for hotels, which attract both vacationers and business travelers when the economy is strong. In a downturn, business travel also dips as companies forego sending people on longer-distance trips unless an absolute necessity.
Retail can also be a risky investment, particularly nowadays as more people shift from bricks and mortar retail to online shopping. This has reduced the demand for retail real estate, something that will be exacerbated in a recession when consumer retail spending drops.
Finally, speculative investments of any kind are best avoided prior to a recession. A development deal in a third-tier market, for example, might promise double digit returns today, but could grind to a halt if a recession hits. There are plenty of examples of half-finished development deals that languished between 2007 and 2008 when the last recession hit. Many investors lost their shirts as a result of investing in speculative deals.
Where to Put Your Money During a Recession
Baron Rothschild, an 18th century British nobleman and member of the Rothschild banking family, is famous for having said “the best time to buy is when there’s blood in the streets;” a quote that Warren Buffett routinely cites, and a strategy he has historically deployed. Essentially, what Rothschild (and Buffett) is saying is that a recession is a great time to invest. Be ready and willing to capitalize on the fear of others who tend to run away from real estate during a recession. This is when some of the best deals can be had.
Specifically, a recession can be a great time to scoop up properties in primary markets. Many investors will get in over their heads (typically, by being too highly levered) in advance of a recession. Many will be forced to sell their well-located properties at a discount during a recession, which opens the doors for an investor who wouldn’t have been able to afford these properties otherwise. Use any recession as an opportunity to buy into top-tier markets while you can.
Best Investments During a Recession
Multifamily has long been a darling of the commercial real estate world, and it’s no wonder why. Multifamily real estate tends to outperform other asset classes despite economic swings. As noted above, demand for multifamily often increases during a recession as homeowners are displaced and forced back into the rental market. Even as the economy improves, multifamily will tend to remain in high demand as there will be people whose savings and/or credit have been negatively impacted and this makes it unable for them to buy a home.
That said, don’t just invest in multifamily real estate blindly. Be sure the bones of the property are solid. Look for a property that has been well maintained and professionally operated, especially if you are investing in a larger apartment community. It may be worth foregoing short-term yield for a lower-risk deal, which means focusing on Class A real estate instead of Class B or Class C value-add opportunities. A recession is a great time to invest in exceptionally well-located properties when they’re available at a discount. Centrally-located properties in walkable, urban areas that are surrounded by amenities tend to hold their value well over time.
As noted above, student housing is another great investment to make during a recession, particularly student housing in primary markets near the nation’s top colleges and universities. Senior housing, industrial facilities and self-storage properties are also attractive investments during a recession. These properties continue to remain in high demand, particularly with America’s aging demographic and the demand for last-mile warehouse properties to accommodate the explosion of next-day retail shipping. Self-storage is a good investment during a recession because as people are forced to sell their homes or downsize, many will need a temporary storage solution by the way of self-storage.
Lastly, consider refinancing any properties that have a higher than market-rate debt. The Federal Reserve Bank tends to cut interest rates during a recession in an attempt to boost economic activity. Take advantage of these lower interest rates to secure the lowest debt possible, ideally locked in for long-term periods (e.g., fixed at 15, 20, or 30-year periods).
What to Do During Recovery
An economic recovery is a good time to start improving your properties, particularly if you had invested in any Class B or Class C real estate. This is a good time to begin renovations and start adding amenities that renters will be increasingly willing to pay a premium for as the economy improves. If you picked up these properties at a discount during a recession, you should have growing equity as the economy improves, so leverage this equity to make improvements that will continue to increase the value (and cash flow) of your portfolio.
The recovery period is also a good time to consider developing land and/or redeveloping multifamily properties to accommodate more, larger, or higher-end units. For instance, if you purchased two neighboring duplexes during the recession that, combined, sit on 1.5 acres of land, you may be able to redevelop the two properties into a 10+ unit apartment building. It’s possible that you’ll need to seek a variance from the local municipality in order to do so, but municipalities are more inclined to grant variances like these during the early stages of an economic recovery as a way of boosting local growth and development.
Few investors can “time” the market with any real accuracy. Ultimately, it’s important for investors to remain focused on their bigger-picture investment strategy. Those who start investing early will have a long-term horizon in which the market will experience several fluctuations.
Those who stick to the basics, investing in quality real estate in strong markets with experienced partners will be the best positioned to weather inevitable economic ebbs and flows. As noted above, there are ways to prepare for a recession, and certain investments that tend to be more recession-proof than others. Follow these investment strategies to help yourself better weather any economic storm that may come down the road.