by Terry Painter, author of “The Encyclopedia of Commercial Real Estate Advice“
Sorry to start with a disclaimer, but with the exception of buying a commercial property occupied by a credit tenant like Walmart or the federal government that has an insanely high credit rating and 20 years or more remaining on the lease, nothing is truly recession-proof. The Gap, which had a fair credit rating of BB+ in March of 2019, was downgraded toward junk territory with a BB– a year later as a result of stiff competition from online sales and the start of the coronavirus recession. Then they stopped paying rent in April of 2020 after furloughing 80,000 employees and their credit rating tumbled further. The same month, Staples, Mattress Firm, and Subway stopped paying rent. These were all considered good tenants.
Does this mean that commercial property is just too risky to invest in? No. What it means is that just like in all recessions, the coronavirus recession — which was the worst economic tsunami to hit global financial markets since the Great Depression — nearly wiped out hospitality and wounded office and retail properties. Apartments, flex-industrial, self-storage, and mobile home parks seem to always make it through with much less pain.
Many of my clients are just sitting on the edge of their seats waiting for the next recession to hit. They have cash ready to grab good properties at great prices. For their existing properties, they put cash aside to protect them for the next recession, along with other recession-proofing strategies. They did this in the same way someone buying property in a storm surge area in Florida prepares for the inevitability of a hurricane. In a moment I share with you the 10 best recession-proofing strategies.
In most markets, a recession causes commercial real estate values to go down. This is because there is lower demand, and financing becomes more stringent, resulting in fewer buyers being able to qualify. Even though interest rates are usually low during recessions, lenders lend less by lowering their LTVs, raising vacancy, and raising their underwriting interest rate. Appraisers get pressured by lenders to lower valuations by having appraisals reflect lower occupancy, higher credit loss, and rent concessions.
According to Wikipedia, during the 60-year period between 1960 and 2020 there were 10 recessions in the United States, or an average of one every 6 years. If you are buying a commercial property and are planning on a long-term hold it would be smart to pick a strategy that will recession-proof you and your property. What you really want to know is this: If your occupancy takes a dive, how low can it go and still allow you to pay all expenses and your mortgage payment? Can you hang in there until things get better? What resources will you have to enable you to survive?
Which commercial property investors do the best during a recession? During the Great Recession that started in December 2007, my clients who had bought commercial properties with a long-term hold strategy weathered the storm better than those who planned on a short-term hold. The latter group intended to make a bundle in the future and pulled cash out to buy more properties. Although property values went down and occupancies dropped for properties held by many of the long-term hold borrowers, most made it through until occupancy and property values went up again. How did they pull this off? Most had chosen a more recession-friendly property and had enough cash or other sources of income to ride it out. In contrast, some short-term investors who had bought properties to rehab and flip got hurt because once they had completed the renovations the lease-up period was too long because the recession had already started. They just did not have enough capital left to make the mortgage payments, and many in this group lost their properties.
The 10 Best Recession-Proofing Strategies
1. Have working capital and other sources of income.
Yes, cash is king! There is absolutely nothing that can make you and your commercial property more recession-proof than a nice chunk of cash. Having additional sources of income is a lifesaver too. Working capital is a rainy day fund used to pay unplanned-for repairs, or in the event of a recession to help with expenses and even mortgage payments. Do a quick pro forma on your property to determine what the expenses and mortgage payment will average each month. Then for a multi-tenant property bring occupancy down to 65% and calculate the monthly shortage you have after paying all expenses and the mortgage. Your working capital fund should be 12 to 18 months of this shortage.
2. Find a property with a break-even ratio that is 75% or lower.
The break-even ratio tells you the minimum occupancy you need to pay all of your expenses and the mortgage on the property. Keeping this at 75% or lower is the next best recession safety strategy after having a stash of cash.
3. Don’t over-leverage.
Plan to reduce your personal debts and make sure that all your investment properties are purchased with at least 25% down. It’s a lack of positive cash flow that ruins commercial property investors during a recession. One of my clients owned a beautiful historic eight-unit apartment building in San Francisco that was thriving through the Great Recession. But it was the four distressed apartment buildings in Sacramento purchased with 15% down seller financing that took him down. He lost the San Francisco property because he drained it of cash to cover the shortages on the Sacramento properties, which he ended up losing, too.
4. Refinance with lower payments.
Having lower payments on all the properties you own, including your home, will give you extra positive cash flow during a recession that can be used on investment properties that are not able to make it on their own.
5. Buy a property at below its value.
There is nothing better that you can do than to buy a property for an even lower price than what it is worth. Let’s say that you brilliantly take $125,000 off a $1.5 million purchase price. Well, first of all, think about how long it would take for you to raise rents and lower expenses to earn an additional $125,000 from the property. Most importantly, this windfall will enable you to take out a smaller loan, thus lowering your monthly payments.
6. Keep your rents below market.
I know, this sounds like leaving a lot of money on the table. But think about it. During a recession, rents get lowered and some tenants move to less expensive properties. If you already have lower-than-market rents, your tenants won’t be leaving and you will be attracting renters from more expensive properties. My client who owns a shopping center in Louisville, Kentucky, keeps his rents about 15% under market. I have scolded him for this. But his intention is to keep his property full during both good and bad times and he has. I have a client in Eugene, Oregon, who owns two apartment complexes, a 36 and a 61 unit. He made it through the Great Recession unharmed and is collecting 96% of his rents during the coronavirus recession. He says this is because his rents are lower than his competitors’ in his submarket. He always stays full for the same reason. And during bad economic times his tenants don’t want to risk losing their homes.
7. Choose a recession-friendly property type.
Multifamily, medical office, self-storage, and flex industrial properties, as well as mobile home parks and senior housing, have a much better chance of making it through a recession unscathed. In 2008, multifamily occupancy grew as more people lost their homes and moved into apartments. Many of the same people rented self-storage units to hold the stuff that did not fit in the apartment. Mobile home park occupancy stayed strong during the Great Recession. Flex industrial complexes weathered the recession too, with small spaces having reasonable rents occupied by a large variety of businesses.
8. Don’t buy at the top of the market.
This is hard to do if you are buying during a seller’s market. Little adds value to a property like not overpaying for it. In an up market you will have to work harder to find decent deals. If there are no good deals, just wait until the market comes down.
9. Choose a multi-tenant property with many smaller units.
If you buy a four-unit office or retail building and two tenants fail during a recession, you could be left with 50% occupancy and be underwater. Also, stay away from retail and office properties where one tenant occupies 20% or more of the total space. The exception to this rule is anchored retail.
10. Find a property that has many value-add opportunities.
Buy a property where you can do two or more of these lower-cost value adds: make cosmetic changes and raise rents, increase occupancy, lower general expenses, lower taxes and insurance, optimize lease potential, and attract higher paying tenants. Put together a buyer’s pro forma that shows the financial gains from your value adds and that you will obtain a lower break-even ratio in the near future. Boy, does this make your property recession-proof!
Time and Money Saving Tip.
One of the best ways to make a killing during the recession and recovery phases of the real estate market cycle is to have the cash ready to buy a distressed seller out fast. When you submit your letter of intent to the seller or listing agent, include a letter of pre-approval from a bridge lender that states they can close in two weeks. If you can pay cash, mention that you will provide verification of funds upon request. Bridge loans are expensive but well worth it if you can buy the property for the right price. Buying well below market means you will be recession-proofing the property right out of the gate.
*Reprinted from “The Encyclopedia of Commercial Real Estate Advice” by Terry Painter, with the permission of the publisher. Copyright © 2021 by John Wiley & Sons, Inc. All rights reserved.