The recent economic news seems to cast shadow on the global economy: US PMI fell to the lowest level since financial crisis; Germany is on the brink of recession; Fed intervened repo market for the first time since 2008 to prevent liquidity crisis in the financial system. As a matter of fact, it has injected cash in the amount equal to nearly 10% of its balance sheet. As the outlook of a recession is more probable than ever, how should real estate investors position themselves and mitigate these macro risks?
Luckily, for folks investing in multifamily/workforce housing, we believe it is actually safer to invest in this asset class than paper assets such as stock and bonds during recessions for two reason:
1. The demand for housing, especially workforce housing, will not be materially impacted by economic outlook. Everyone needs a roof above his/her head, and for B/C class multifamily, the vacancy increase may be mitigated as more people will look for downsizing from A class apartments or single family if they lose their job/can’t afford mortgage etc during economic downturn. The same will be even more evident for manufactured home communities.
2. The valuation approach of the workforce housing gives the owner more control on their valuation. Unlike single family houses where the price is determined by comparable in the neighborhood, multifamily and manufactured home communities can maintain its value by increasing the Net Operating Income (NOI), which offsets the widening cap rate during recession. There are many ways to increase the NOI, such as upgrading units, reducing nonessential expense and renegotiating contracts. This topic alone can be expanded into an article for itself.
That said, how can an investor further mitigate the risk when getting into a deal during economic uncertainties? here are a few things that one can do:
1. Pick a city with diversified job base. Historically, the real estate markets in certain cities are like roller coaster that swings ups and downs during various stages of economic cycle as their economy is dominated by one or two sectors. Others tend to be more stable as it has a diversified economy and not one company or sector would drive the job growth of the city. Picking a city that is well diversified in employment opportunities is one of the easiest way to not get burned during economic downturn.
2. Choose long term financing. Obtaining a loan with long term maturity (7-10 years) is extremely important during downturn as it allows you to hold onto the property. The worst case scenario is that you are forced to sell a property at bargain price when the loan comes due the next day but you cannot secure other financing sources. That said, for certain value add properties that the sponsor has a plan to refinance within 2-3 years, a bridge to agency loan structure may still make sense provided there are contingency plan if no agency debt is available when bridge loan matures.
3. Cashflow from Day One. This is one of the most important factors that can determine life or death for an investment. If the property is not cashflowing, it adds additional burden when the economic situation worsens and the revenue growth falls through. On the other hand, if the property has sufficient cushion to make sure it still cashflows even when occupancy drops, this will ensure the asset can withstand the downturn without additional capital injection. Ideally the break-even occupancy rate (the % of units occupied by tenants so that the rent revenue can pay off all expenses as well as mortgage payment) should be in the mid 70 level.
No one has crystal ball and knows for sure what will happen tomorrow. But this is not an excuse to not invest. Think of people from 2014-2015 who wait on the sideline in hope of a recession to occur. Instead, if one can understand what makes an investment safer and invest conservatively, this would allow you to build a better financial future for you and your family even during uncertain times.
