Steady as she goes-choosing investments that help mitigate recession risks is possible

Four defensive strategies commercial real estate investors can use to weather storms and potentially stay the course

Although peaks and troughs are inevitable parts of the economic cycle, recessions are rare and typically difficult to predict. With the “R” word dominating news cycles, everyone is wondering–is a recession right around the corner? And what will it look like if and when it does arrive?

Recessions are typically defined as a significant slowdown in economic activity, generally accompanied by spikes in unemployment, decreased consumer spending, and interest rate fluctuations. To help insulate their portfolios from uncertain markets, many investors look for alternative investment options that have the potential to provide some degree of risk mitigation and help protect possible returns. While no investment is recession-proof, strategic investments in commercial real estate (CRE) could help mitigate the effects a recession may have on your portfolio, hopefully buoying you to calmer waters and providing the opportunity to exit your investment during a future growth cycle.

While real estate investments carry risk, even during a booming economy, if you’re looking to “play defense” and possibly insulate your portfolio from market fluctuations, consider the following when evaluating potential CRE investments for your portfolio:

1. Long weighted average lease terms (WALT) and credit-worth tenants

Think of each CRE investment as a business in itself, the potential profitability of which depends on the Net Operating Income (NOI), essentially the property’s revenue minus the necessary operating expenses (utilities, maintenance, debt payments, etc). NOI is tied directly to healthy occupancy levels and the creditworthiness of tenants in the property. Historically, during the height of past recessions, most CRE owners saw declining profits thanks to rampant unemployment and low demand for CRE, which pushed vacancy rates up and left these businesses (and ergo the investments) with depleted NOI and, therefore, bleak profitability.

One way to insulate an investment against a decline in tenant demand associated with a recession is to have strong, creditworthy tenants in place, especially those with long weighted average lease terms, or WALT, which translates to the blended average lease term of all tenants in the property on a dollar-weighted basis. During a recession, a longer WALT can help a property ride out the downturn. If a property encounters a recession but does so with strong, stable tenants in place–like major retailers in a shopping center with 10+ year leases– who may be more likely to have the ability to continue to fulfill their lease obligations, the center can continue to operate, service its debt, and “weather the storm” until the next growth cycle. This ability to potentially earn during a downside scenario is often referred to as “durable cash flow” and a reason why including investments with a long WALT and strong tenant credit-worthiness in your portfolio can be a strong defensive operating strategy for investors.

2. Long-term durations on debt

One of the biggest changes that the CRE industry can experience during a recession is a decline in overall market liquidity, which means it becomes tough to acquire debt or equity for transactions. For instance, total U.S. CRE transaction volume dropped nearly 87% from 2007 to 2009. One of the contributing factors was a nearly frozen debt market, meaning lenders were simply not offering lines of credit to potential CRE buyers due to high perceived risk.

Usually CRE is purchased or built with a combination of debt and equity, typically with debt exceeding the amount of equity. If debt becomes difficult to obtain, then it’s more difficult for existing properties to be purchased by new owners or for developers to pay for the construction of a new property. Frozen debt markets can further deteriorate market liquidity as they discourage prospective buyers, which removes more liquidity from the market in a kind of domino effect.

During a weak and illiquid market, properties that face debt maturities, meaning the principal amount of their debt becomes due, likely find themselves in one of two less than ideal scenarios. First, in the event that the property owner elects to sell the property to pay off the loan, they are likely to face a scarcity of buyers. Of the interested buyers, it’s likely that their offers will be disappointingly low, making it difficult for the current owners to sell and hence pay off their matured debt. Secondly, for those who do not want to sell, they are faced with the task of refinancing the property to pay off the current loan and to avoid foreclosure. Unfortunately, the bank appraising the property is doing so in that down market, which can mean a lower valuation overall, resulting in a lower loan amount. This can mean the owner has to come up with a sizable amount out of pocket to make up the difference between the refinanced loan and the existing property debt. 

If the owners aren’t able to make up the difference, they become forced sellers, a situation comparable to getting a margin call on your stock portfolio and being forced to liquidate your portfolio at the bottom.

While it is nearly impossible to forecast future recessions and for sponsors to plan their debt maturities accordingly, it is possible to increase the duration of the loan term. Doing so can decrease the number of debt maturities during the holding period which can lower the probability of a maturity occurring during a recession. Also, keep in mind that even if sponsors do find themselves in a recession upon a debt maturity, if they’ve held the property for 10+ years, they are likely to have an asset that has appreciated enough to refinance it without coming out of pocket.

3. Recession-resiliency based on property type

Good strategies aren’t always about what you should do; sometimes it’s about what you should not do. For example, investing in a CRE property type that is more vulnerable to recession-based risks could potentially hamper the profitability of your investment. The below chart shows that the performance of REITS during the Great Recession (shown in light green) for hospitality, retail, office, and industrial underperformed compared to self-storage, apartments, and healthcare*

Table: Economic Sensitivity in 2019 vs. During Global Financial Crisis

Source: Green Street, Heard on the Beach, “Same As It Ever Was”, 2019.

What the latter, historically recession-resilient group has in common is the relative consistency in tenant demand for these property types. Sectors such as office or hospitality have demand that can ebb and flow in line with employment levels and consumer spending. People still need healthcare and a place to live no matter what is going on economically, offering a sort-of buffer for things like medical facilities and apartments.

* Green Street, Heard on the Beach, “Same As It Ever Was”, 2019. The above graph is for illustrative purposes only.

4. Larger project sponsors with multi-cycle track records

When things get difficult, who you are investing with matters. By looking for sponsors that have a track record that shows how they navigated previous downturns, and seeking sponsors with healthy balance sheets, some of the elements of concern related to a recession may be alleviated.

Larger and more tenured sponsors generally tend to have stronger depth and breadth of relationships in their respective markets. When there is only one tenant choosing between two properties, usually the stronger landlord would win the deal.. When markets are expanding, this aspect of investing can be easy to overlook, but it matters a lot when markets take a turn for the worse. As we say in the industry, when it comes to CRE, picking the jockey may be more important than picking the horse

What's the trade-off?

We’ve all heard it: you have to step out of your comfort zone to grow. The risk-return tradeoff is an investment principle that indicates that the higher the risk, the higher the potential reward, although nothing is ever guaranteed. The same can be said about your investment strategy. When choosing alternative investments like CRE to include in your portfolio, it is important to be clear about the level of risk you are comfortable taking on. Is your portfolio largely aggressive or defensive in its strategy? Seeking recession-resilient investments is an inherently defensive strategy, which may have the potential to mitigate risk for your overall investment returns during economic slowdowns. However, a defensive strategy can be a double-edged sword. Each time you opt for more certainty as a way to de-risk an investment, it’s likely you are also opting into a lower targeted annual rate of return. Thus, it is important to evaluate your risk-reward goals for your overall portfolio when evaluating ways to mitigate the effects of recession risk.

Different project sponsors will pursue different strategies, some of those aligning with a more offensive or defensive stance. There are ways to optimize a private CRE investment for the amount of risk you are willing to take based upon your perception of where we stand in the business cycle and your financial goals. Ultimately, the choice is yours.

This article was written by an employee of CrowdStreet, Inc. (“CrowdStreet”) and has been prepared solely for informational purposes. Nothing herein should be construed as an offer, recommendation, or solicitation to buy or sell any security or investment product issued by CrowdStreet or otherwise. This article is not intended to be relied upon as advice to investors or potential investors and does not take into account the investment objectives, financial situation or needs of any investor. All investing involves risk, including the possible loss of money you invest, and past performance does not guarantee future performance. All investors should consider such factors in consultation with a professional advisor of their choosing when deciding if an investment is appropriate. Investing in commercial real estate entails substantive risk. You should not invest unless you can sustain the risk of loss of capital, including the risk of total loss of capital. All investors should consider their individual factors in consultation with a professional advisor of their choosing when deciding if an investment is appropriate. Direct and indirect purchase of real property involves significant risks, including without limitation market risks, risks related to the sale of land, and risks specific to a given property, which could include the potential for property value loss, potential for foreclosure, changes in tax status and fees, and costs and expenses associated with management of such properties. All investors should consider risks specific to that given property prior to investing.

CrowdStreet, Inc. (“CrowdStreet”) offers investment opportunities and financial services on its website. Broker dealer services provided in connection with an investment are offered through CrowdStreet Capital LLC (“CrowdStreet Capital”), a broker dealer registered with FINRA and a member of SIPC. Advisory services are offered through CrowdStreet Advisors, LLC (“CrowdStreet Advisors”), a wholly-owned subsidiary of CrowdStreet and a federally registered investment adviser.

 






 

 

 

 

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