Whenever pessimism dominates the U.S. economy, commercial real estate investors should be prepared to shift their positions. With inflation at 40-year highs, interest rates rising and monetary tightening underway, there seems to be a consensus that the nation is heading toward a financial downturn.
While the likelihood of a global recession is not certain, commercial real estate professionals need to take the long view. This means that changes in the short term may be necessary to avoid ending up on the wrong side of the balance sheet. Based on my experience in the industry, here are five ways that commercial real estate investors can prepare for the looming recession and protect their bottom lines.
1. Keep decent liquidity.
Cash will be king when banks freeze up on lending. This doesn’t necessarily mean keeping large amounts of cash on hand—lines of credit should suffice. This way, you keep your assets but also have access to cash when needed, helping you stay afloat and cover any cashflow shortfalls while enabling you to take advantage of buying opportunities.
One should remain mindful that when things get tough, some banks historically have chosen to shorten or outright close lines of credits if they perceive borrowers as high risk, even if the account has zero balance or is otherwise fully performing and current. When setting such lines of credit secured by real estate, I recommend doing so with lenders with whom you have no other loans and avoiding those you typically use for traditional commercial lending. This will reduce the chances of your credit line getting frozen when you need it most.
The number one reason people lose assets and get wiped out during recessions is high leverage and not enough liquidity. If you have $100 in assets and $70 of debt (70%), I’d rather see you sell 50% of your assets and pay down your debt so that you have $50 in assets but only $20 of debt (40%). Your equity position doesn’t change (it will still be $30), but during a downturn, I recommend keeping leverage to no more than 50%—ideally 30% to 40%. From past experiences, it seems to be a magic number to avoid leveraged assets getting in trouble—in actuality or on paper—and help you avoid lenders calling in covenant defaults, which will ultimately lead to the loss of an asset.
3. Refinance any upcoming or maturing debt.
Make sure balloon payments on your debt are at least five—and ideally seven to 10—years out so you can weather the downturn. Your assets may go vacant and potentially into covenant default over the next five to seven years as the economy goes through recession and recovery. Ideally, you should refinance any debt with non-recourse debt and negotiate covenant default provisions upfront. Most lenders don’t want to own your properties, so having no personal guarantees on a loan will strengthen your negotiation position and improve your chances of reaching a workout agreement if you do get in trouble.
4. Avoid spec projects.
Defer any major undertakings that will be capital-intensive, that project an exit strategy over the next two to three years, or that have debt otherwise maturing over the next four years. Remember, people lose even fully performing Class A assets during recessions for no other reason than that banks freeze lending and owners are unable to refinance when the underlying debt matures.
If you are in the middle of such projects, I recommend you finish them up as quickly as possible or consider putting them on hold. You don’t want to be scheduled to deliver a major ground-up construction project in the middle of a recession one to four years from now. With that said, I don’t believe we will see dramatic changes in the economy before December due to the upcoming elections, so you probably have time to get out while you can. But once 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 or will soon be obsolete, such as mobile home parks, older industrial buildings with low interior ceilings, multifamily in tertiary markets and office spaces with small wall-to-window ratios and lower ceilings. I would also avoid bigger 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—maybe some in-line, service-based retail or grocery-anchored centers.
Remember, the industrial, retail and office space worlds are changing. What was once considered the gold standard (suburban office space, indoor malls, etc.) are becoming dinosaurs. Be smart and don’t become extinct along with them.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.