How to Prepare for a Downturn
By Percy Nikora, Owner/Co-founder
No one knows when the next downturn will come. There are always signs, but you can’t tell when exactly it’s going to happen. Looking in depth at certain metrics helps. However, it’s not a perfect science.
The truth is that it doesn’t matter if you know a downturn is coming soon or not. You can take steps to protect yourself at any time, and you shouldn’t trust that a great market will stay great forever. Things can change in an instant, so it’s better to prepare for a downturn at the beginning of every project by insulating yourself against as much risk as possible.
Buying Under Value
Our strategy for protecting against downturns is to purchase undervalued properties. These are often the value add projects that need a lot of work before they reach their full income potential.
Buying undervalued projects allows you to build padding into the asset price from the start. Undervalued buildings are often not rent stabilized, and they tend to need improvements. The building is likely to be priced at under market rates because of its condition. By putting sweat equity into this type of building, you can bring its value up over time.
If a downturn hits while you’re in the process of constructing, you can stop spending or thin out operations during the deepest part of the recession. Tighten your operations and squeeze as much yield as possible out of operational cash flows you’re already getting. Run your operation as lean as possible during the lowest market times. As the market improves, you can begin to open up spending again slowly.
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Real Estate Demand
As populations grow on the limited available space on earth, demand for real estate is inevitable. There is virtually infinite demand for housing because people always need a place to live. Just because the demand for housing will always exist doesn’t mean it’s strong in every place all the time. Some areas have more of less demand, but nearly every market in the US will see demand grow gradually over time.
Buying undervalued properties helps you to take advantage of this long-term value growth without taking on high risks. Because you’ve bought at a lower value, you can hold it for the long-term and slowly grow the value over time. It might take years, but you’re not as likely to default.
The one thing you don’t want to do is try to speculate with real estate. Even though it may look like there’s a healthy profit for buying and flipping during a downturn, it’s a risky strategy that can easily backfire on you. In the short-term, properties may not always increase in value. But, given enough time, they almost always do.
Avoid Overleveraging Properties
Another reason many people get into trouble is overleveraging debt on real estate investment properties. Overleveraging in a downturn or before a downturn often leads to default. During a downturn, look to buying stabilized properties with no more than a 70-75% LTV (Loan-to-Value) ratio. This gives you enough cushion in case things do slow down and rents drop or vacancies increase.
Debt services should be within the manageable amount you can handle with your cash flow while keeping everything afloat. For added padding, make sure you could still manage that debt even with a higher vacancy rate.
The best way to accomplish this is with a deep value add property in a good market.
Debt maturity affects you during a recession. For projects with bridge loans, usually redevelopment projects, they have short maturity dates of 2 or 3 years. Doing value add work helps secure the loan by increasing value of the property, allowing for refinancing out later. Otherwise, debt risk can be managed by including optional extensions into the terms of the loan to allow for stabilization.
The closer you feel you are to a downturn, the longer term you want your debt to be and the less you want to be leveraged. It’s not a good position to be overleveraged as the market turns down.
Whether you see signs of a downturn or not, you need to stress test deals. Be conservative. If your normal underwriting assumption would be 2% value growth, stress test at low or no growth.
It’s also important to stress test occupancy and rent growth. What if a downturn occurs and rent growth is only 1% or goes down to -1%? How does vacancy increase affect the deal? You need to know the answers to these and other similar questions.
Stress test as far as you can to see how far vacancy can go before the deal doesn’t work anymore. If it’s a reasonable number, the deal is probably okay. If there’s not enough wiggle room and padding in the deal, that means the risk is likely too high.
Build in the padding so that if your revenue dries up or rent fails to grow, you’re still okay with expenses and debt service. Don’t get into a deal where you have to grow at the average rate or higher in order for the deal to work.
During a downturn, you can still get caught up in debt or expenses, no matter how much planning you put into a deal. There will always be risk. If you don’t want any risk, don’t get into real estate.
The key is to mitigate risk and have a conservative risk profile that allows you to carry on with your operations to outlast the market. If you can get to the other end and begin to grow the property’s value again, that will be your success to enjoy.
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