April 28th blog post, A Gathering Storm: 8 Indicators a Recession is Looming, must have hit a nerve with my readers. It turns out that this article is my second most read blog post of all time.
In this article I identified four economic indicators suggesting that the American public is tapped out financially and four indicators that business activity is also slowing. I concluded the article by saying the U.S. economy is beginning to slow down and there is nothing the Trump Administration can do to stop it from happening.
The big question is when will it happen? It could happen later this year or it may not happen till next year. It’s anybody’s guess. Understand this important point: Economic expansions don’t die of old age. Typically, a recession is triggered by an adverse event causing panic among the investor class which then sends the market spiraling out of control. Mob psychology takes over. What could be the trigger? It could be a sudden collapse of an overpriced stock market in the United States. Or possibly it could be the collapse of the real estate bubble in China. It could be anything. And until that adverse event happens this economy will continue to limp along.
But the real point of the article was to motivate you to get prepared. We know a recession is going to happen. It’s inevitable. Why not prepare for it while you still have time to maneuver and plan your strategy? Don’t wait until the recession is upon you. There are things you can do now to lessen the negative consequences of a recession.
That’s how I concluded the article. I was purposely vague as to what you could do today to lessen the turmoil from an impending recession. Some of my readers wanted to know my thoughts on this topic. So today I pony up practical suggestions for both investors and commercial real estate professionals that can help all of us to not only survive the next recession, but to thrive when the economy begins growing again.
Recession Planning for CRE Investors
1. Build a cash reserve. Now may be the time to forgo owner distributions to build a cash reserve, also known as a rainy-day fund. One of the biggest mistakes investors make is not having sufficient cash reserves when times get tough. They like the cash flow being generated during the good times and are happy to pocket it for other purposes but they conveniently forget the negative consequences of rising vacancy on the property’s cash flow. Do you have sufficient reserves set aside for tenant improvements and leasing commissions should the downturn cause abnormally high vacancy at your property?
2. Change the term of your loan. Is your loan coming due within the next couple of years? During the Great Recession, many investors lost their properties, not because they were delinquent on their mortgage payments but because they were unable to refinance their existing loan at the same loan amount. Or it could be that the property owner fails other financial ratios the lender uses to assess an investor’s financial strength and liquidity that prior to the Great Recession they would have had no problem passing with flying colors.
I had a client who built a Class A multi-tenanted office building that at the time of construction was worth about $5 million. The ten-year loan came due at the height of the recession. The property’s vacancy rate at that time was nearly 40%. In order to refinance he needed to pay down the existing loan by about $1 million. But he didn’t have the money to pay down the loan and he couldn’t refinance the property. So even though he had paid every mortgage payment on time for the ten years of the loan, the lender ended up foreclosing on the property.
So how do you avoid that from happening to you? Is your loan coming due during the next few years? If so, you may want to consider refinancing now with a loan term of five years or longer as historically economic downturns don’t last for extended periods of time. If your property’s occupancy rate plummets as a result of the coming recession you won’t have to refinance at the peak of the recession.
3. Another reason to refinance your property is to improve the property’s cash flow. If the last time you financed your property was more than 3 years ago, it is likely the current interest rate is higher than what you could get today. A lower interest rate will reduce the mortgage payment and make your property that much more resilient to a market down turn.
4. Do your capital repairs now. Are there capital repairs that likely need to be completed over the next 3 years at the property? Are you putting off re-painting the exterior, or repairing, resealing and restriping of the parking lot or replacing the roof? Maybe now is the time to make those needed repairs when the property is flush with cash instead of waiting to do the work when the recession hits and cash flow is limited at best.
5. Do a vacancy breakeven analysis on all your properties. Based on your current rent roll and operating expenses, what vacancy rate will result in the property’s cash flow before debt service equaling the mortgage payment? At the height of the Great Recession, apartments averaged a 10% vacancy rate, industrial properties averaged about a 15% vacancy rate and office and retail probably averaged around a 20% vacancy rate. How well does your property do with these vacancy rates? If it can still breakeven with these types of vacancy rates you’re probably okay. If not, now’s the time to make the changes necessary so it can. Do your own breakeven test. If you would like a formula to fill out to accomplish that, let me know.
Recession Planning for CRE Professionals
1. Build a cash reserve – How much? Enough to last at least 12 months without any income. Two years would be better.
2. Forgo expensive and/or questionable purchases. Prior to the Great Recession, I had a friend who was a commercial real estate professional. He lived paycheck to paycheck. When he received a larger than normal commission check, he’d go out and buy the hottest shiny new man toy. The thought of saving money for a rainy day was foreign to him. You see, his spending behavior had a lot to do with his personality which is prevalent among commercial real estate professionals.
Most of us in this business are cock-eyed optimists. We are glass half-full type of people. We have to be in order to succeed and flourish in this business. It requires that type of personality to survive all the negative things that happen until you become a success. But unfortunately, when the Great Recession hit, he wasn’t able to survive the downturn. He lost his job, his house and declared bankruptcy. He currently is out of commercial real estate altogether.
Don’t let that happen to you. Maybe now is not the time to purchase that new car or take that expensive vacation or buy that new house you’ve always dreamed about.
3. Invest in yourself in such a way that potential clients can differentiate you from your competition. Get that CCIM or SIOR designation. Sign up to be coached by a well-respected CRE professional. When the business slows down, be one of the survivors. Make it obvious to potential clients that you have something to offer them that other real estate professionals do not.
4. Stop using the equity in your home as your personal piggy bank. As I mentioned in my last article, consumers have forgotten the lesson from the last recession: Those who borrow end up losing everything. Credit card debt, auto loan debt, student loan debt and home mortgages are collectively at an all-time high. Pay off your consumer debt now. Stop using the equity in your homes as your personal piggy bank. Now is the time to get your financial house in order.
How many properties did investors lose because of the Great Recession that could have been avoided if they had done a bit of recession planning? And how many real estate professionals could have survived the recession if they had done some prudent planning during the good times? Don’t let that happen to you this time around. If you do, I may lose a blog reader and I wouldn’t like that. 🙂