by Terry Painter, author of “The Encyclopedia of Commercial Real Estate Advice”
We’re sorry to start with a disclaimer, but nothing is really recession-proof except for buying a commercial property rented by a credit tenant like Walmart or the federal government with insanely high credit ratings and a remaining term of 20 years or more. The loophole, which had a fair credit rating of BB + in March 2019, was downgraded to a BB in junk territory – a year later due to stiff competition from online sales and the onset of the coronavirus recession. Then, in April 2020, they stopped paying rent after taking 80,000 employees on leave and their creditworthiness continued to decline. In the same month, Staples, Mattress Firm, and Subway stopped paying rent. These were all considered good tenants.
Does this mean commercial real estate is just too risky to invest in? No. What it means is that just like all recessions, the coronavirus recession – the worst economic tsunami to hit global financial markets since the Great Depression – has all but wiped out hospitality and wounded office and retail properties. Apartments, flex industrial, self-storage and mobile home parks always seem to do it with much less pain.
Many of my clients just sit on the edge of their seats, waiting for the next recession. You have cash ready to buy good real estate at affordable prices. For their existing properties, they are putting cash aside to protect them for the next recession, along with other recession protection strategies. They did this in the same way that someone buying property in a storm surge area in Florida prepares for the inevitability of a hurricane. In a moment, I’ll share with you the 10 best recession protection strategies.
In most markets, a recession causes commercial real estate values to decline. This is because the demand is lower and the financing becomes tighter, which means fewer buyers can qualify. Although interest rates are typically low during recessions, lenders lend less by lowering their LTV, increasing vacancy rates, and increasing the subscription rate. Appraisers are pressured by lenders to lower their ratings by providing appraisals reflecting lower occupancy, higher loan losses and rental concessions.
According to Wikipedia, there were 10 recessions in the US in the 60 years between 1960 and 2020, or one every 6 years on average. If you are buying a commercial property and planning a long-term commitment, it is wise to choose a strategy that will make you and your property recession-proof. What you really want to know is this: when your occupancy takes a dive, how low can it be and still allow you to pay for all expenses and your mortgage payment? Can you hold on until it gets better What resources will you need to survive?
Which Commercial Real Estate Investors Do Best During a Recession? During the great recession that began in December 2007, my clients who bought commercial real estate with a long-term hold strategy weathered the storm better than those who planned a short-term hold. The latter group intended to form a bundle in the future and pulled out money to buy more real estate. Although property values fell and the occupancy of properties held by many long-term borrowers fell, most made it to upward trend. How did you do that? Most had settled on a more recession-friendly property and had enough cash or other sources of income to dispose of it. In contrast, some short-term investors who bought real estate for rehab and flip were hurt because the rental period after the renovations was complete, as the recession had already started. They simply did not have enough capital to make the mortgage payments, and many in that group lost their property.
The 10 Best Strategies to Protect Against Recessions
1. Have working capital and other sources of income.
Yes, cash is king! There is absolutely nothing that could make you and your commercial property more recession-proof than a nice chunk of money. Having additional sources of income is also a lifesaver. Working capital is a rainy day fund that is used to pay for unplanned repairs or, in the event of a recession, to cover expenses and even mortgage payments. Take a quick pro forma action on your property to see what the average monthly expenses and mortgage payments are. Then for a property with multiple tenants, reduce the occupancy to 65% and calculate the monthly shortage you have after paying all the costs and the mortgage. Your working capital fund should be affected by this deficiency for 12 to 18 months.
2. Find a property with a break-even ratio of 75% or less.
The break-even ratio will tell you the minimum occupancy you will need to pay all of your expenses and the mortgage on the property. Keeping this at 75% or less is the next best recession-proof strategy after a stash of cash.
3. Don’t be fooled.
Plan to reduce your personal debt and ensure that all of your investment properties are bought with a decrease of at least 25%. It’s a lack of positive cash flow that ruins commercial real estate investors during a recession. One of my clients owned a beautiful eight-unit historic home in San Francisco that flourished during the Great Recession. But it was the four distressed Sacramento homes that were bought with 15% less seller financing that put him down. He lost the San Francisco property because he was supplying it with cash to meet the constraints on the Sacramento properties, which he eventually lost.
4. Refinance with lower payments.
Getting lower payments on all of the real estate you own, including your home, will provide you with particularly positive cash flow during a recession that can be used on investment properties that can’t do it on their own.
5. Buy a property below its value.
There is nothing like buying a property at an even cheaper price than what it’s worth. Let’s say you brilliantly save $ 125,000 on a purchase price of $ 1.5 million. First, think about how long it would take to raise rents and lower costs to earn another $ 125,000 from the property. Most importantly, with this coincidence, you can take out a smaller loan and thus lower your monthly payments.
6. Keep your rents below the market.
I know it sounds like leaving a lot of money on the table. But think about it. During a recession, rents drop and some tenants move to cheaper properties. If you already have rents lower than the market, your tenants will not leave and you will attract tenants from more expensive properties. My client, who owns a mall in Louisville, Kentucky, keeps their rents about 15% below market. I berated him for it. But his intent is to keep his property full in both good times and bad, and he has. I have a customer in Eugene, Oregon who owns two apartment complexes, a 36 and a 61. It weathered the Great Recession unscathed and is collecting 96% of its rents during the Coronavirus Recession. He says that’s because his rents are lower than those of his competitors in his submarket. It always stays full for the same reason. And in bad economic times, its tenants don’t want to risk losing their homes.
7. Choose a recession-friendly property type.
Multi-family, doctor’s office, self-storage and flex industrial properties, as well as mobile home parks and senior housing, have a much better chance of surviving a recession unscathed. In 2008, multi-family occupancy increased as more and more people lost their homes and moved into apartments. Many of the same people rented self-storage units to store the things that didn’t fit in the apartment. The occupancy of mobile home parks remained strong during the Great Recession. Flex industrial complexes also weathered the recession with small spaces with reasonable rents occupied by a variety of businesses.
8. Don’t buy at the forefront of the market.
This is difficult when you are buying during a seller’s market. Little increases the value of a property because it doesn’t pay too much. In an upscale market, you have to work harder to find decent deals. If there aren’t any good deals, just wait for the market to drop.
9. Choose a multi-tenant property with many smaller units.
If you buy a four-unit office or retail building and two tenants are down during a recession, you might be 50% full and underwater. Also, stay away from retail and office properties, where a tenant occupies 20% or more of the total area. The exception to this rule is anchored retail.
10. Look for a property with a lot of added value.
Buy a property where you can do two or more of these lower cost value additions: make cosmetic changes and increase rents, increase occupancy, lower general expenses, lower taxes and insurance, optimize rental potential and attract higher paid tenants. Put together a buyer’s pro forma process that shows the financial gains from your value creation and hits a lower breakeven point in the near future. Boy, does that make your property recession-proof?
Time and money saving tip.
One of the best ways to commit murder during the recession and recovery phases of the housing market cycle is to have the money ready to quickly buy a distressed seller. When you present your letter of intent to the seller or listing agent, include a pre-approval letter from a bridge lender stating that it can be closed in two weeks. If you can pay in cash, please indicate that you will provide a cash verification if requested. Bridging loans are expensive but worth it if you can buy the property at the right price. If you buy well below the market price, you are recession-proof right from the start.
* Reprinted from “The Encyclopedia of Commercial Real Estate Advice” by Terry Painter with permission from the publisher. Copyright © 2021 John Wiley & Sons, Inc. All rights reserved.