The high inflation rate has resulted in a 10%-12% increase in building costs, affecting developers’ expected cashflows and project completions.
Is Commercial Real Estate Truly Recession-Proof? Let's Find Out!
Real estate investors are afraid because of the economic catastrophe brought on by the COVID-19 epidemic. Many people wonder if real estate is recession-proof. In actuality, real estate has outperformed other assets during prior financial crises or recessions, leading some investment experts to refer to it as a recession-proof investment.
Unprecedented economic instability has been released by the current COVID-19 health crisis, and not only in India. The public markets’ volatility has greatly grown as a result of this. Given its illiquid nature, commercial real estate typically reacts to economic shocks like this one considerably more slowly, but the effects are undoubtedly already starting to be felt. It’s crucial to be ready for recessions like these whether you’ve been investing for a while or are just starting started. Investors may survive recessions that endure for several months to many years by employing particular tactics. This article examines how to build a recession-proof portfolio.
How does recessions work?
The easiest way to conceptualize a recession is as a general reduction in commercial and economic activity. Recessions can be identified by a decline in the GDP from quarter to quarter or an increase in the unemployment rate, among other indicators. Different sectors might be impacted by recessions. For instance, it takes longer for the commercial real estate market to experience the effects of a downturn in the economy. Because real estate is more difficult to buy and sell than public instruments like stocks and bonds, it takes longer to adjust to changes in the economy. Realizing the effects of decreased yields might take many months. Similar to how other asset classes can quickly recover, these effects can last longer.
During a recession, commercial real estate prices nearly always see some kind of drop. As a result, investors should anticipate more appealing purchasing opportunities in a bear market than they would in a booming economy (a bull market).
Building a Recession-Resilient Portfolio: Strategies
When aiming to build a recession-proof portfolio, commercial real estate investors should take a few broad ideas into account.
Investors should want to save as much money as they can, especially if there are any signs that a recession is imminent. To avoid engaging in transactions only for the sake of engaging in transactions entails exercising patience and discipline when it comes to fresh investing prospects. This will guarantee that when a recession hits, an investor will have funds available to invest in lucrative ventures.
Secure a secure, long-term loan (usually)
By securing long-term, fixed-rate loans, one may hedge against interest rate and debt maturity risk. Investors that think a recession is imminent would wish to think about financing deals using fixed-rate loans and 7–10 year credit durations. Without having to be concerned about debt maturity during that period, this is sufficient time to weather a recession and emerge from it in a strong financial position.
Think about Holding Period
Many investors wonder if there is an “ideal” holding time to take into account while creating a portfolio that is recession-resistant. There is no perfect holding time. The holding time should instead be in line with the overall business plan. The investor must then take into account where the economy is in the cycle to decide whether or not that holding time may raise or lessen risk.
For instance, an investor who recently invested in a deal with a 5- to 10-year holding term would not be very concerned about the possibility of a recession. Rarely do recessions endure for several years?
Because of this, an investment with a 5 to 10-year holding term allows the sponsor plenty of time to put their business plan into practice and still emerge on the winning side. When a recession is in full swing, the sponsor can step back, assess the situation, and navigate it. This can entail delaying the pace of rent increases, value-add activities, and capital upgrades in favor of maintaining a high level of tenancy and steady rents.
Of course, the risk of a recession is higher for an investment with a 5- to a 10-year holding period that is getting close to the conclusion of that time. In situations like these, investors would have to be concerned about a loan coming due during a time of economic unrest. Due to their greater ability to negotiate the financial markets, especially during a downturn, experienced sponsors with solid loan ties are essential when investing.
How to Invest in Advance of a Recession
Our goal at Assetmonk has been to make investments in “need-based” asset classes. Need-based assets are asset classifications that will always be in demand, regardless of where the economy is in the cycle, such as flats or senior housing. People will always require a place to live, as in multifamily housing. In reality, during a recession, more individuals will need to rent, raising demand among those who would otherwise be unable to buy.
We have mostly invested in Class B multifamily buildings, to be specific. These assets, in our opinion, provide the most flexibility. However, in the case of a market decline, these value-add initiatives can be placed on hold while the property still delivers positive cash flow for investors. There are certain chances to use value-add measures to increase revenue. In most locations, Class B buildings may still be rented for significant savings above Class A properties while still drawing attention from a wide variety of prospective tenants. During a recession, Class A tenants who want to save money by moving downstream to still excellent, refurbished Class B properties frequently make up the renter pool for Class B properties.
That does not imply that Class B properties are immune to economic downturns. Basis remains of utmost importance. As a recession approaches, investors won’t want to overpay for Class B buildings. The difference between Class A and Class B rentals should be taken into account by investors as well. Let’s suppose Class A new building has a $400–$600 rent premium. There is still enough of a cushion if these costs drop by a few hundred dollars to make Class B flats more appealing to tenants on a budget. In other circumstances, Class B property owners will have to reduce their rents as well to compete in a downturn. To determine how negative rent growth could affect a deal’s viability, it is crucial to stress test underwriting assumptions before investing and especially in advance of a recession.
Diversification is something that real estate investors should aim towards. Any investor wanting to diversify their portfolios away from simply stocks, bonds, and other traditional instruments is someone who is investing in real estate. Investors should diversify their real estate assets as well. Diversification may be viewed from several perspectives. Various product categories (such as multifamily vs senior housing), multiple property classifications (Class A, B, C), various regions, various sponsors, and more might fall under this heading.
By diversifying their real estate assets by the sponsor, product type, property class, etc., investors will inevitably wind up making investments across a range of regions. An investor must consider the demand factors that shape the regional economy within each location. Demand factors vary by geography and are more or less resilient to recessions.
Naturally, investors will want to take a close look at any recent increase in new home stock in these areas as well, since this might be a sign of increased competition. This includes taking a look at things that have previously received permission and are in the works but are not yet being built. There are no inherent problems with the new supply. Indeed, if there is sustained demand, markets with fresh supply may be excellent places to invest. Not every new supply is inherently competitive. New Class properties, for instance, might not be able to compete with Class B or Class C properties. However, new supplies can draw in additional customers, and in regions with robust economic drivers, other employees, such as service workers, can follow suit and support market expansion. The demand for Class B/C homes will increase as more people move into a region.
Where to Invest in a Recession
Each investor has a unique recession plan. Our strategy is to take a step back and assess the market’s environment. How long do you anticipate this recession to last? Months? Years? It isn’t always obvious. However, investors need to pay close attention to how the market is moving. After that, each investor should review their current portfolio as their first action. Analyze its ability to withstand a declining market. Make whatever modifications are required to weather the recession, then practice patience and self-control.
Buying possibilities that are distressed typically arise during recessions. However, in the majority of situations, it’s the capital stack that is in trouble rather than the real estate. As a result, finding opportunities where the real estate’s fundamentals are robust—with a strong tenant base, strong demand drivers, and more—but where the capital stack is under pressure for one reason or another, is one method for investing during a recession. We are highly interested in such changes, especially when a reputable sponsor is supporting the deal.
Where to Invest After the Recession
Investors should have created robust portfolios before the crisis that contain reliable investments that fared well during the economic downturn. They will have made smart investments throughout the crisis, such as investing in projects at a reduced basis given pressured circumstances and investing with quality sponsors in the face of a limited pool of purchasers. Those who took these actions both before and throughout the recession will be in a good position to boost their portfolio development following a recovery.
Readjusting underwriting expectations is necessary when investing during a recovery phase. Investors may be more risk-averse early on in recovery than they are later on. For instance, an investor could be more eager to engage in development ventures in the early phases of recovery. In the early stages of a recovery, investors might maximize value by front-loading risk.
We are currently experiencing a variety of recessions, as we are discovering firsthand. The recession we are approaching as a result of the COVID-19 problem differs significantly from the one that occurred in 2008–2009.
It is still unclear how long and in what direction this recession will last. We are aware that it will have an effect on the commercial real estate market as a whole, but we believe that some property types may be more affected than others. Investors may need many months to fully comprehend the impact of the pandemic on commercial real estate. Price changes may take even longer to take effect for opportunistic purchasers.
Although few investors anticipated a worldwide health catastrophe, there have been other signs of a recession for some time. No matter how long this slump lasts, those who have carefully built a recession-resistant portfolio will be in the greatest positions to survive it.
Do you also intend to make a commercial real estate investment? Assetmonk is a WealthTech platform that offers chances to invest in commercial real estate of institutional caliber. We only provide properties after performing extensive due investigation, and our offerings have an IRR ranging from 14 to 21%. It also offers partial ownership of the commercial real estate. Contact our staff if you want additional details.
One of the finest ways to invest during a recession is multifamily housing. Apartments have a rich history of being an asset type that performs well in both prosperous and difficult economic periods. It’s a mixed bag for other commercial property during a recession.
Three of the previous five recessions saw an increase in property values, and investors who played their cards well were able to make sizable profits. Being a long-term investment unaffected by transient events, residential real estate is regarded as the best recession-proof investment.
People may put their homes on the market when they move for new work during a recession, which is typically characterized by significant unemployment. Additionally, it can result in more foreclosures, which would raise inventory levels. Prices will probably decrease as a result of increased supply at a time when demand is already declining.