Economic storm clouds are gathering. Interest rates are climbing, inflation is rising, companies once stellar are laying off employees, small businesses are on the ropes, there’s uncertainty in the housing market and the stock market, and a recession is on our doorstep. As a commercial real estate investor, how do you navigate and capitalize on an economic crisis?
“This Time Is Different.”
These are the four most dangerous words in real estate investing. I have personally weathered three economic downturns and recessions impacting commercial real estate, and experience tells me that these four words are dangerous to the investor. “This time is different,” is totally false. What may be different are the variables, the symptoms, where and how the crisis may hit, but the crisis itself is not different. Some will fail, others will prosper; some will succumb to the economic crisis while others will capitalize on it. My goal is always to come out on top, and to do that I use four principles to guide my decisions and prosper in an economic downturn. Without these guiding principles, most will be doomed to fail.
4 Guiding Principles of Commercial Real Estate Investing
- Minimize Speculation: These days with a looming recession, job layoffs and high inflation, there’s no room for speculation. Every deal must be a winner or you could sink in an economic storm.
- Be a Good Manager: In commercial real estate investing, managing your investments is important if you want to excel. This means managing the numbers, the property manager, and every aspect of the business.
- Always Buy on Cash Flow: Commercial estate is a cash flow business, and buying on cash flow is critical to success.
- Never Over-leverage: This seems like it would be obvious, but you would be surprised at how many commercial real estate investors are over-leveraged, even in a struggling economy.
Get Cycle Tested Advice
The first step to capitalizing on the current economic crisis is to seek advice from someone who has been through it before. I have personally experienced three economic downturns and have learned that there are different phases to each one. Real estate cycles move with the economy, and there are four phases to each cycle. And I can say without hesitation having a mentor who had gone through economic downturns helped me early on to navigate the commercial real estate cycle.
Phase 1: Recovery
The first phase in a real estate cycle is the recovery phase. This is when we have a buyers’ market like in 2008-2012 when the US economy was down but recovering. This was also the time to buy. It was a scary time, but prices were low, and now are more than double, and in some cases they have even tripled. Those who invested then created a lot of wealth.
Phase 2: Expansion
The expansion phase is the seller’s market, and this has been the phase we are in since around 2012. For ten years now sellers have been commanding higher prices, and as investors we have been paying those prices because the values continue to rise.
Phase 3: Recession
The next phase after expansion is recession, and we enter what is called the balanced market. I think this is where we are about to be. Many think that coming out of a seller’s market means a buyer’s market is coming, but this is incorrect. What follows is a balanced market, and here is why that is.
In the current market, many investors are low balling, making offers below asking price, and this is simply due to interest rates being so high. High interest rates mean lower cash flow, making high asking prices unaffordable. What this creates is a gap between what buyers offer and sellers ask. That’s why it is called a balanced market, and these markets take skill and wisdom to navigate. These are also times when sticking to the four guiding principles becomes even more important; buy on cash flow, don’t speculate, be a good manager, and don’t get over leveraged.
I think we are at an important moment in the current cycle. In the balanced phase, and considering the current economy, you need to be very careful who you get advice from. To navigate this moment you need a mentor who has experienced each phase and knows what to expect during a recession.
Phase 4: Excess Supply
The final phase of the commercial real estate cycle is a buyer’s market once again. Once you get out of the balanced phase, supply outpaces demand, and there are lots of deals to be made.
3 Key Property Types for Today’s Economy
I believe there are three specific commercial niches that are excellent for our current economy. Each of these allow investors to prosper during economic down times.
1. Multifamily
Multifamily real estate is an obvious choice for several different reasons. When inflation is out of control and interest rates are rising, it can be a boom for rentals. In fact, we will likely look back in a year and see that the federal policies have driven the greatest rental boom in American history. You can already see it beginning to happen, and apartment investors are going to see demand rising and with it rents.
2. Storage Facilities
Storage facilities include everything from self-storage to RV storage, and even industrial warehouses. Storage is a good investment no matter what the economy is like. People simply need places to store all the things they buy. But during an economic downturn, many will downsize, and they will need somewhere to store their stuff in the interim.
3. The Mobile Home Park
Mobile home parks can be a great investment for several reasons. One, there aren’t a lot of them being built, so supply is limited, making their demand high. But in an economic downturn they become even more desirable since they are a more affordable housing option, and there is a shortage of affordable housing in the US today. As the economy retracts, demand for mobile homes will rise.
3 Key Investment Strategies
When you invest in times of economic uncertainty, you need to implement these three strategies.
1. Conservative Underwriting
Underwriting is about evaluating the risk potential and financial returns of your commercial real estate deal. This is the tool we use to determine the value of a property, and the potential cash flow. When the economy is uncertain, or if it is certain to get worse, conservative underwriting is critical. In a recession your risks go up, and so your cash flow projections need to be conservative. Maybe on paper you predict a rental income increase, but it is good to be conservative in your projections.
This applies to your Return on Investment (ROI) as well. You need to temper your expectations here too because interest rates and operating costs have risen significantly, while rents have remained fairly stable. This will impact your ROI, so you need to be conservative in your underwriting.
2. Loan Balloon Date
The second strategy during an economic crisis has to do with your loan balloon date. When you purchase residential real estate you can lock in fixed interest rates for 30 years, which can be fantastic, especially if you did this when rates were very low. But commercial real estate is different. Commercial lenders lock in rates for five, seven, or ten years that are amortized over 30 years. This means that when your loan matures, you will need to refinance.
The problem is, if your loan balloons in five years and interest rates are higher when you refinance, the high interest rate may kill your cash flow. So you need to be conservative with your numbers going in and try to get a longer commercial loan of seven or ten years to lock in your numbers longer.
3. You Need an Exit Strategy
This final strategy is critical, and many investors really don’t consider it on the front end. Having an exit strategy can be really important during tough economic times. In fact, you may want to have more than one exit strategy because there are so many variables in the market. Your strategy may be to hold the property for seven years, sell it and exchange it for a larger property. Or maybe you do a cash out refinance and pull money out to buy another property. Whatever the case, you need an exit strategy going into the deal.
Planning an exit strategy is like looking into the future. And the best way to do that is to get advice from someone with experience, who has seen the ups and downs of commercial real estate in good times and during economic uncertainty. Beginning investors can only see what’s happening right now, while investors with decades of experience are better equipped to see where the market is going.
