What is a Recession?
A recession is best thought of as a widespread decline in overall business and economic activity. Recessions can be measured in several ways, such as a reduction in gross domestic product (GDP) in consecutive quarters, or by increases in the unemployment rate. Recessions can impact sectors in different ways. It takes longer for the commercial real estate market, for example, to feel the impacts of an economic recession. Real estate, given its illiquid nature – i.e., it cannot be purchased and sold as easily as public securities, like stocks and bonds – takes longer to respond to economic upheaval. It may take months for the impact of declining yields to be realized. Similarly, these impacts may linger for longer than other asset classes that can readily bounce back.
Commercial real estate prices will almost always decline to some degree during a recession. As such, investors can expect there to be more attractive buying opportunities during a recession (a bear market) than when the economy is strong (a bull market).
Strategies for Building a Recession-Resilient Portfolio
There are a few general strategies for commercial real estate investors to consider when trying to create a recession-resilient portfolio.
Maximize in-place yields.
At Alpha Investing, we place an enormous emphasis on in-place yields. When evaluating opportunities, we look at the rents, positive free cash flow, the spread between interest rates vs. going-in cap rates, and more to determine how an asset will perform from day one. Let’s use the example of acquiring an asset with a 5% going-in cap rate and a 3.5% fixed-rate loan. The positive spread between the cap rate and interest rate is accretive to the deal, providing strong in-place cash flow to equity holders. In the event of a recession, in-place cash flow provides an important buffer to insulate investors and preserve capital.
Compare this to a development deal. When a recession hits, a development deal may be at greater risk given the lack of existing cash flow. Let’s say that a development project is six months into an 18-month construction cycle. During a recession, construction costs could go up, capital might dry up, and even if the property is ultimately completed, it will still need to be leased and stabilized. There’s no existing structure with rents in place, creating more downside risk for investors.
Any investor who thinks we may be on the brink of a recession may want to focus on deals with strong in-place yields as a way to endure the potential risks associated with an economic downturn.
Preserve liquidity.
Investors may want to preserve as much liquidity as possible, particularly if there’s any indication a recession is in the near future. This means maintaining patience and discipline as it relates to new investment opportunities rather than doing deals for the sake of doing deals. This will ensure that an investor has cash freed up to deploy into opportunistic deals when a recession takes hold.
Lock in stable, long-term debt (usually).
One way to hedge against interest rate and debt maturity risk is by locking in long-term, fixed-rate debt. Investors who believe we’re on the cusp of a recession may want to consider financing transactions with fixed-rate debt and 7-10 year loan terms. This is long enough to endure a recession and come out in a good position on the other side, without having to worry about a loan maturity during that time.
Now, the COVID-19 crisis has created an interesting situation in which variable-rate loans are actually benefiting more than fixed-rate loans. Nobody anticipated the economy coming to a grinding halt in this manner. However, it has created a unique set of circumstances in which the federal reserve has aggressively slashed interest rates, which benefits variable rate loans. A lower interest rate creates its own form of buffer in the event of nonpayment of rent. That said, there’s typically more short-term risk associated with variable rate loans, particularly those with shorter loan terms. Such loans can certainly make sense as well, depending on the nature of an investment’s business plan and the quality of the sponsor behind the investment.
Consider Holding Period
Many investors ask whether there’s an “ideal” holding period to consider when building a recession-resilient portfolio. There’s no ideal holding period. Rather, the holding period needs to be aligned with the overarching business strategy. Then an investor must consider where we are in the economic cycle to determine whether that holding period potentially increases or decreases risk.
For example, an investor who has just put money into a deal with a 5 to 10-year holding period might not be altogether concerned with the threat of a recession looming on the horizon. Recessions rarely last several years. Therefore, an investment with a 5 to 10-year holding period gives the sponsor plenty of time to implement their business strategy and still come out on the upswing. In the midst of a recession, the sponsor can take a step back, evaluate the environment, and manage through the downturn. This might include slowing down the pace of capital improvements, value-add strategies and rent increases, focusing instead on keeping the asset highly occupied and rents stable.
Of course, an investment with a 5 to 10-year holding period that is nearing the end of that term faces a greater risk of a recession. In cases such as these, investors may need to worry about a loan coming due during a period of economic upheaval. This is why it is critically important to invest with experienced sponsors that have strong debt relationships; they are better equipped to navigate the capital markets, even during a downturn.
What to Invest in Before a Recession
At Alpha Investing, our strategy has been to invest in “need-based” asset classes. Need-based assets refer to those like apartments or seniors housing, asset classes that will continue to be in need regardless of the stage of the economic cycle. For example, with multifamily housing, people will always need somewhere to live. In fact, more people will need to rent during a recession, thereby increasing demand among those otherwise unable to buy.
Specifically, we have primarily invested in Class B multifamily properties. We find these properties offer the most flexibility. There are some opportunities to deploy value-add strategies to improve income, but in the event of a market correction, these value-add investments can be put on hold while the property still generates positive cash flow for investors. Class B properties can still be rented at a meaningful discount to Class A properties, at least in most markets, while attracting interest from a broad range of potential renters. During a recession, the renter pool for Class B properties often includes Class A renters looking to save money by moving downstream to still high-quality, renovated Class B properties.
That is not to say that Class B properties are recession proof. Basis is still critically important. Investors will not want to overpay for Class B properties heading into a recession. Investors will also want to consider the spread between Class A and Class B rents. Let’s say there’s a $400-$600 rent premium for Class A new construction. If these prices come down by a few hundred dollars, there’s still enough of a buffer to make Class B apartments more attractive to price-conscious renters. In some cases, Class B owners will need to drop their rents as well to remain competitive during a recession. This is why, prior to investing and especially in advance of a recession, it is important to stress test underwriting assumptions to see how negative rent growth might impact the success of a deal.
Real estate investors should also strive for diversification. Anyone who is investing in real estate is inherently looking to diversify their portfolio away from just stocks, bonds, and other traditional securities. Further, investors will want to diversify their real estate holdings. There are a few ways to look at diversification. This could include diversity of product types (e.g. multifamily vs. senior housing), different property classes (Class A, B, or C), various geographies, sponsors, and more.
Those who diversify their real estate holdings, by product type, property class, by sponsor, etc. will inherently end up investing in diverse geographies. Within each geography, an investor must look to the demand drivers for the local economy. Different geographies have different demand drivers that can withstand recessions to varying degrees. Of course, investors will want to look at any recent influx of new housing in these geographies as well, which could indicate greater competition. This includes looking at what is already permitted and in the pipeline but not yet under construction. New supply is not inherently problematic. Indeed, markets with new supply can be great areas to invest assuming there’s sustainable demand. New supply isn’t always necessarily competitive. For example, new Class A properties may not be competitive with Class B or Class C properties. However, new supply can bring in more people, and in areas with strong economic drivers, other workers, like service workers, may follow suit and contribute to overall market growth. The more people moving to an area, the more demand there will be for Class B/C housing.
Where to Invest During a Recession
Every investor has a different recession strategy. Our approach is to step back and evaluate the context of the market. How long is this recession expected to last? Months? Years? It’s not always apparent. Nevertheless, investors should be monitoring changing market conditions closely. Thereafter, the first step any investor should take is to reevaluate their existing portfolio. Determine how well it is positioned to absorb a down market. Make any adjustments necessary to endure the recession, and then exercise patience and discipline.
A recession often gives way to distressed buying opportunities. However, in most cases, it’s not the real estate that’s distressed, but rather the capital stack that has come under pressure. As such, one strategy for investing during a recession is to identify opportunities where the fundamental real estate is solid—there’s strong in-place cash flow, a strong tenant base, strong demand drivers and more—but where the capital stack is under duress for one reason or another. Such opportunities are particularly appealing to us, especially when there’s a high-quality sponsor behind the deal.
Where to Invest Post Recession
Ideally, investors will have built strong pre-recession portfolios boasting solid investments that weathered the economic storm well. They will have made strategic investments during the recession, including investing with quality sponsors amid a smaller pool of buyers and investing in deals at a lower basis given duress situations. Those who have taken these steps, pre-recession and during the recession, will be well-positioned to accelerate the growth of their portfolios during a recovery.
Investing during a recovery period requires a re-setting of underwriting expectations. Early in a recovery, investors may be willing to take more risk than later in the recovery. For example, investors can create maximum value by front-loading risk early on in a recovery, investing in projects such as development deals.
Conclusion
Recessions can take many forms, as we’re learning in real time today. The recession of 2008-09 looks much different than the recession we are entering into as a result of the COVID-19 crisis. The direction and duration of this recession remains to be seen. We know that it will have an impact on the commercial real estate industry at large, but suspect it may have a greater impact on some property types compared to others. It could take months for investors to really understand the full depth of the pandemic’s impact on commercial real estate. Opportunistic buyers may find that price adjustments take even longer to materialize.
While few investors predicted a global health crisis, there were other indicators that a recession was looming on the horizon for some time now. Those who have carefully crafted a recession-resilient portfolio will be best positioned to weather this downturn, regardless of how long it lasts.