Nikita Zhitov, CityPlat, LLC.
Whenever pessimism dominates the US economy, commercial real estate investors must be prepared to shift positions. With inflation on Highlights in 40 yearsas interest rates rise and monetary tightening is underway, there appears to be a consensus that the nation is headed for a financial downturn.
While the likelihood of a global recession is uncertain, commercial real estate professionals need to look to the long term. As a result, changes may be necessary in the short term in order not to end up on the wrong side of the balance sheet. Based on my industry experience, here are five ways commercial real estate investors can prepare for the looming recession and protect their bottom line.
1. Keep decent liquidity.
Cash will be king if banks freeze lending. This doesn’t necessarily mean you have to keep large amounts of cash on hand – lines of credit should suffice. This way, you keep your assets, but also have access to cash when you need it, so you can stay afloat and cover any cash flow shortfalls, while taking advantage of buying opportunities.
It should be remembered that when the going gets tough, some banks have historically chosen to shorten or close lines of credit completely if they consider borrowers to be high risk, even if the account has zero balance or is otherwise fully performing and current. When establishing such real estate-backed lines of credit, I recommend doing so with lenders with whom you have no other loans and avoiding those you usually use for traditional commercial loans. This reduces the chance that your credit line will be frozen when you need it most.
The main reason people lose assets and get wiped out during recessions is high leverage and insufficient liquidity. If you have $100 in assets and $70 in debt (70%), I would rather you sell 50% of your assets and pay off your debt so that you have $50 in assets but only $20 in debt (40 %). Your stock position won’t change (it will still be $30) but during a downturn I recommend keeping the leverage at no more than 50%, ideally 30% to 40%. Past experience shows that it is a magic number to prevent leveraged assets from getting into trouble – in real life or on paper – and to prevent lenders from defaulting on covenants, which will ultimately lead to the loss of assets.
3. Refinance any upcoming or maturing debt.
Make sure balloon payments on your debt are at least five — and ideally seven to 10 — years so you can weather the downturn. Your assets could become vacant and potentially in default for the next five to seven years as the economy moves through recession and recovery. Ideally, you should refinance any debt with non-recourse debt and pre-negotiate standard terms in the covenant. Most lenders don’t want to own your properties, so not having personal guarantees on a loan will strengthen your bargaining power and increase your chances of reaching a training deal if you run into trouble.
4. Avoid specific projects.
Postpone large companies that will be capital intensive, that propose an exit strategy for the next two to three years, or that have debt maturing in some other way in the next four years. Remember, people lose even fully performing Class A assets during recessions for no other reason than banks freeze credit and owners are unable to refinance when the underlying debt matures.
If you’re in the midst of such projects, I suggest you finish them as soon as possible or consider putting them on hold. You don’t want to have to deliver a major construction project from the ground up in one to four years, in the midst of a recession. That said, I don’t believe we’ll see dramatic changes in the economy before December as a result of the upcoming elections, so you probably have time to get out while you still can. But when the midterm elections are over, I think we’ll see a lot of blood in the water.
5. Focus on recession-proof investments.
Personally, I would avoid investing in buildings that are outdated or soon to be, such as mobile home parks, older industrial buildings with low interior ceilings, multi-family homes in tertiary markets, and office spaces with small wall-to-window ratios and lower ceilings. I would also avoid larger box retail as consumers and retailers move to e-commerce. Instead, consider focusing on recession-proof assets such as medical offices and flex/small bay industrial that cater to service industries — perhaps some in-line, service-based retail or grocery shopping centers.
Remember that the worlds of industrial, retail and office space are changing. What was once considered the gold standard (suburban office space, indoor shopping malls, etc.) are becoming dinosaurs. Be smart and don’t die with them.
The information provided here is not investment, tax or financial advice. You should consult a licensed professional for advice on your specific situation.