Commercial real estate, in general, is considered a good hedge against inflation. As a landlord, you have the power to increase rental rates to soften the blow of rising expenses.
When inflation is driven by substantial economic expansion, rents continue to rise, buildings remain entire, and landlords can rely on a steady source of income.
But worries about long-term economic sluggishness are making CRE investors question this strategy. Strained corporate balance sheets could limit the ability of tenants to pay more rent, jeopardizing investment returns.
In addition, as debt costs rise, CRE investors with office towers, hotels, shopping malls, and similar property types—which are primarily considered overpriced by today's standards—may find their returns dwindling.
Many people in the industry believe that a market correction is imminent. When the economy sours, your first impulse may be to re-strategize your portfolio. Investing in recession-proof CRE assets might help to even out stock holdings.
Commercial real estate fares better than many other investment classes when the economy slows down and can still be used as a natural hedge against volatility—but only if you take the right approach.
Let's go back to 2007. Commercial property values were soaring, and CRE investors worked late into the night, trying to find properties to buy that would give them a good return on their investment.
They didn't know then that they were buying at the top of a six-year bull market and may soon lose their shirts. Then, the Great Recession started in December, and the real estate market tanked.
A similar nose-dive happened in March of 2020, after a 10-year up-seller's market that didn't look like it would ever end. Then, the recession triggered by the coronavirus began to bite.
Some 33 million people applied for unemployment insurance during the seven weeks from March 26 to May 7.
But before all this happened, it was like everyone in the real estate industry had forgotten recessions were even a thing. The lesson? Learn from history and never be too complacent.
Recessions in the US occur every six years, lasting anywhere from 8 months to about 1.5 years. So it's possible that the COVID-19 pandemic was a fluke—a once-in-a-century occurrence.
But recessions happen, and they happen often. So don't let your guard down.
The effects of a recession on commercial property values differ from their effects on residential values. Residential real estate reacts mainly to a lack of demand and oversupply.
Many people lose their employment due to the recession, resulting in their inability to pay off their mortgages on time.
This causes several properties to be sold at once, along with an overabundance of foreclosed homes sold at a reduced price.
Commercial property values rely mostly on NOI or net operating income. This consists of gross rental income and expenses.
In times of a recession, many commercial properties face the challenge of reduced occupancy and late payments. This lowers the NOI, thereby lowering the property's value.
There are four real estate market cycles, each with its peaks and valleys. For example, suppose you're looking to buy a commercial investment property.
In that case, you must identify which phase of the cycle you're currently in to make a financially savvy decision on how much to pay.
Early on in an economic recession, some investors don't want to come to terms with the reality that their properties are now worth less money.
So many CRE sellers try to dispose of their assets at pre-recession prices. But after being in denial for around four months, they start to come face-to-face with the situation, and prices dip as a result.
Then, seven months later, foreclosures hit their highest point, making it an ideal time for buyers to swoop in.
When unemployment has fallen significantly for two consecutive months while rental rates and vacancies have stabilized, the economy has reached the recovery stage. CRE values rise to previous levels during this phase. Therefore, if you manage to time your purchases in the early months of this phase, you are likely buying at the bottom of the property market, which is the most optimal time to buy.
This phase is a seller's market. Higher rental prices and low vacancy characterize it. Construction is back in full swing. Even if you're late to the party, this may be a fantastic time to get a fairly-priced property with potential value-add elements, such as under-market rents. But you'll need to work hard to uncover excellent deals.
This happens when too many units are available on the market due to over-building. As a result, prices remain high even though rents are decreasing. This is the absolute worst time to purchase CRE, especially value-add properties.
To illustrate just how important it is to determine what phase the property market is in, let's revisit a classic CRE story. In the last quarter of 2007, a CRE investor purchased an apartment complex with 186 units in Oklahoma City.
The deal seemed like a profitable value-add opportunity. Priced at $6.8 million, this class C building built in 1984 looked beautiful compared to others at that time.
It was put on the market because the previous owner ran out of funds after rehabbing all except 34 apartment units, which sat vacant.
These apartments still had their original linoleum floors, outdated cabinets and fixtures, and Formica countertops.
Keep in mind that all this was happening during a hyper-supply phase. New multifamily properties were popping up everywhere, and the market was flooded with too many choices for renters.
The investor was planning to spend upwards of $340,000 to upgrade the apartment units during a hyper-supply phase—which, in hindsight, the $6.8 million asking price was too high.
But the seller didn't budge, and the investor was determined to buy the building. And so the deal happened.
The investor managed to complete the rehab reasonably quickly—in just seven months—but even this was not enough. By then, the market was already thick with the Great Recession.
Many existing tenants defaulted on payments. Lease-up on the freshly remodeled apartments was slow.
By that time, the investor didn't have enough liquidity and lost the building just a little over a year after buying it.
Learn to identify what phase of the real estate market cycle you're in to avoid overpaying for a commercial building and purchasing at the top of the market.
Instead, ensure the property generates more than enough NOI to survive a recession and maintain its value.
Even during an economic downturn, some commercial properties will continue to prosper.
For example, warehouse space and farmland may still be in demand as people require necessities like wheat products and corn. Therefore, investing in land that can be used to produce these types of commodities can prove to be a smart move, even during tough times.
Senior housing is worth a look, too. Given that the population is aging in the US, there will likely always be a demand for senior homes regardless of whether there's an economic recession.
Student housing can also be a good investment because students still need a place to live while attending school.
If you want to invest in commercial properties but don't want to obtain a loan to buy and manage an actual building, you may invest in real estate investment trusts (REITs) or through real estate crowdfunding platforms.
REITs and real estate crowdfunding can be great options for passive investors because they provide the benefits of having CRE assets in one's portfolio without the risks and hassles of owning a property. You can also try investing in exchange-traded funds (ETFs) or real estate stocks.
If you're planning to purchase a commercial investment property, you may be able to get it at a discounted price during a recession.
This is good news if you have limited capital or are interested in buying more than one CRE property to create several income streams.
And while it's nearly impossible to time the market and knows when it will hit bottom or reach its peak, profit will be made in the in-between area.
You don't have to swim in cash to take advantage of the opportunities. Partnering with a reliable, full-service CRE investment firm can give you the agility to act at the right time.
In addition, they can give you quick access to capital not available from traditional banks.
Capital Investors Direct offers a wide range of financing solutions for commercial real estate investors. Talk to us today about your current or planned projects so we can recommend the best financial deals from nontraditional lenders.
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