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2 Smart Ways to Make Money Investing in Real Estate in the Coming Recession

Expertise: Real Estate News & Commentary
18 Articles Written
Multifamily-apartment

Full transparency, "thriving" during a recession might be a strong word. What does "thrive" really mean, anyway? Outperform other investments on a relative basis?

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So far, what we’re seeing at the institutional level is that buyers are looking for a small discount but nothing too crazy, and sellers are holding out to see if this will pass before reducing their expectations. I’d love to see some comments below about what people are seeing in the $5-25 million space from those active in that range, as the larger stuff just isn’t trading much yet.

So for now, when I say “thrive,” I’m not talking about buying at steep discounts and making 2012 purchase-level IRRs. I mean these investments should do well on a relative basis.

In this article, I’ll walk you through a part of the process I’ve been going through while thinking about navigating this market.

How to Navigate the Current Economy

First, let’s think through the macro picture a bit. Over the next several months, we’ll continue to see high unemployment, weak retail sales, a tempered consumer, some deflationary pressure, and an overall sluggish economy.

We know that unemployment has hit hardest in the blue-collar, low- to moderate-income segment of the population. This demographic also tends to be renters.

We also know from history that the multifamily sector held up very well during the last recession on balance and well-located Class B/C assets. And manufactured housing did particularly well, meaning they saw rents decline by a lesser amount than other assets. The reason for this is somewhat obvious: People always need a roof over their heads. While there may be some downsizing and combining, ultimately rent is going to be the last payment to cut for many people.

Real estate valuation is not only a function of cash flow based on real estate fundamentals. It is also a function of capital markets, and how much value the market is willing to pay for and lend against that cash flow.

On the fundamental front, looking at supply and demand, I think it’s safe to assume some softness on the demand front from the spike in unemployment and a general shift in preferences toward looking for better value rather than paying top dollar for all of the bells and whistles. We also see big spikes in supply and new deliveries that had been scheduled to pop up in 2020.

Some of these projects may get delayed or canceled, but most of the construction was probably already underway. And a significant investment—and construction loan—were already deployed. So most of these construction projects will probably be delivered upon.

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This tells me that over the short-term, properties may have a hard time pushing rent growth in the second half of the year, or even into 2021, as the economy stabilizes. We may even see that the rent declines noted over the past two months become persistent and rents go flat or even continue to decline a bit more. This will be very market-specific in its impact.

On the capital markets front, so far there is still a tremendous amount of appetite for deals. Buyers are still willing to put money to work and are looking for bargains. But as mentioned above, bargains aren’t materializing yet at the institutional level.

We're seeing insurance firms, pension funds, investment funds, and family offices with a lot of money to deploy. So long as the prevailing narrative remains that the Federal Reserve can save everyone and keep asset prices high with QE infinity, and so long as there will be a strong economic recovery later this year, this equity will remain hungry.

Related: Landlords: Here’s How to Survive Rent Moratoriums and Suspended Evictions

If that is the case, cap rates can remain low and even go lower (believe it or not), even as NOI declines a bit. However, this can turn on a dime if psychology shifts to expectations of a longer-term decline with a more questionable recovery. We’ve got to be really nimble here to make sure we’re navigating this properly.

Smaller equity investors, syndicators, and the like may be having a tougher time. (Please reply in the comments or message me directly if you have a good feel for that market segment because I’d love to learn more.)

Lending is the real wildcard here. I’m hearing that banks are cautious to lend and are requiring large reserves and guarantees from borrowers. We’re not seeing this to as great of an extent with larger institutions, at least in the segment we’re playing in.

One potential trend worth watching carefully is a bifurcated market where larger, well-capitalized players continue to be active in large deals, while smaller segments of the market find a harder time with financing and "retail" investors don't maintain the same level of interest as larger institutions.

If this is the case, we may see some bargains in smaller deals while larger deals hold up a little better. However, unless sellers really start to overwhelm buyers, we can’t bank on seeing across-the-board vicious valuation declines just yet—though we should allow for the possibility.

How to Pick a Niche That Works in Many Environments

Some of the more aggressive investors out there may be over-optimistic about the economic prospects post-COVID-19. I tend to fall into the camp that believes there may be some more carnage ahead and that a risk-off mentality may still emerge among real estate investors and lenders.

If that happens, we may see rising cap rates in conjunction with falling NOIs and, therefore, much lower prices. We may start seeing distressed assets and the ability to find really compelling deals.

With that in mind, any investments we make today must be positioned to both do well if the market rebounds strongly and hold up in an environment where the situation deteriorates further. We should also be keeping some dry powder handy to capitalize on better deals down the road—should they materialize.

I love the idea of making asymmetric investments. This means that you invest in something that has a lot of upside and fairly minimal downside.

Moving-from-city

Which Niches Perform Well in Downturns?

Here are the two niches currently on my mind:

Niche #1: Class A Multifamily in Growth Markets

I’m not saying there will be a mass exodus, but on the margin, this COVID-19 business may be the nudge some people needed to decide to make a move. Whether it be job disruption or that they’ve been stewing on it for a while, I think the already in-place trend of people moving out of the Northeast, California, and Chicago will continue.

Cities like Phoenix and Las Vegas have had compelling growth stories for the better part of the last decade, attracting people from the West Coast and across the country.

Related: These States Will Be Hit Hardest by COVID-19 Recession

I personally know a dozen or so people who have bailed on Chicago for Nashville. North Carolina is sometimes referred to as “New York South,” and Florida and Texas also continue to attract new residents from all over the country. Ultimately, the weather, lower cost of living, and far favorable tax climate are going to continue to be a major draw to these areas.

To narrow it down, let’s take a look at metropolitan statistical areas.

I grabbed every MSA with a population over 1 million. Then I eliminated everything with population growth less than 10% from 2010-2019. Then I removed anything on the West Coast, Northeast, and Chicago.

Next thing I’d do is give this list to our super smart analysts and have them pull research reports on all of these markets and start to identify the key submarkets; key employers, as well as trends in employment; where people like to live, work, and play; where new apartment construction is happening; and which assets make the most sense to target.

We can then narrow it down further by eliminating anything newer than 3 or 4 years old to jive with the thesis that the highest-priced buildings may struggle more than a slightly older competitor who can offer lower rents but still a nice place to live.

Let’s also throw out anything older than around 2005, since now may not be the time to complete expensive renovations and ask the tenants for a $200 premium.

What we'd be left with, then, would be a reasonable swath of assets to target that stand to do well if the market rebounds quickly. They should also hold up nicely in a more prolonged downturn due to the long-term growth trends and position in the market.

This would be a good niche if you’re looking to hit singles.

Niche #2: Distressed Asset Lending

This niche would be more well-suited for people looking to hit doubles and triples, However, it requires some more in-depth knowledge and execution risk.

If the lending space remains tight for many borrowers other than the very large and strong institutions, there may be a significant gap to fill in providing loans to real estate investors who have a debt maturity looming and cannot refinance or sell for the right value.

If you can identify the right assets, underwrite them well, and understand the credit risk, there may be an opportunity to get attractive interest rates as a lender. You get the added benefit of being at the top of the capital stack and have the asset as collateral, reducing your risk.

Let’s imagine a sponsor who bought a building last year, using a bridge loan for renovation costs that is now coming due. However, the renovations were slow, and they’ve now lost tenants and not achieved the rent premiums. The value of this building is probably well below what was anticipated, and the bridge lender may be looking to foreclose.

If you believe in the asset and the sponsor, providing a new loan to take out the bridge lender might be attractive, as you could negotiate a strong interest rate with the borrower. Here you’d need to be extremely careful to understand the value of the building and make sure you’re at an acceptable loan-to-value ratio (LTV). If you do need to take over the property down the road, you could be in at a nice value.

Another spin on this same concept would be to network with current lenders that may have notes they are worried about. You can negotiate purchasing the notes for a discount to par value. Earning 7-8% as a lender in a secured position might be attractive relative to an equity investor.

The major caveats to this strategy are:

  • Stick to short-term loans, so an increase in inflation down the road doesn't kill you.
  • Make sure the loan is sized right so that you're in a strong position if there's a default.

Those are the two niches I’m thinking might be attractive.

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Which areas are you targeting?

Let me know with a comment below.

Phil McAlister is a Chicago-area native and real estate investor. With a career that has spanned investment banking, commercial lending, and real estate, he has extensive transaction experience fro...
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    Ricardo A Perez from Hollywood Florida
    Replied 4 months ago
    @Phil McAlister thank for the article very informative for a inspiring investor.
    Barry H. Investor from Scottsdale, AZ
    Replied 4 months ago
    PHIL - great article. As a turn key remodel seller of SFH in Kansas City MO, I am not in that multi-million space you inquired about, but as respects to lending options, I provide Seller-Financing on all my sales to investors who make 20%+ annual returns inclusive focal loan costs and Cap Ex. Interest in my properties has increased since COVID due to the high ROI (I presume), but perhaps more so ease of financing.
    Phil McAlister Specialist from Chicago, IL
    Replied 4 months ago
    That sounds like a nice win-win strategy.
    John Bierly Rental Property Investor from Bainbridge Island, WA
    Replied 4 months ago
    Phil - thanks for the insight. We focus in the $2-10M MF Class B-/C+ market, sub institutional but larger than most mom and pops. As you noted financing is the challenge, Fanny and Freddy are basically nowhere to be seen (insisting on 9-18 mo reserves) and banks being buried processing Federal emergency loan programs. We are currently refinancing 2 properties and have been successful with a local credit union in the low 3% range and with reasonable conditions, but it took awhile, and that with properties at about 8% economic vacancy (on collected rent). A couple of comments; 1) I noticed your filters of "no west coast" effectively swept up Seattle and Portland along with California which I feel is overly broad. We are active outside of Seattle (not in the city core) and are still seeing some opportunities although as you say Sellers have not yet been willing to take much of a haircut and continue to hope they can ride this out, and 2) having had some exposure to distressed lending last time around I would say this typically takes a year or two from the onset of a recession to produce much in the way of loans to purchase - it just takes that long to work its way through the process to the point where lenders are willing to accept significant discounts to get non performing debt off of their books.
    Phil McAlister Specialist from Chicago, IL
    Replied 4 months ago
    Great feedback. I completely agree with you on markets, people who know markets well can definitely make money anywhere. I didn't mean to imply those were the only possibilities, just giving people a glimpse at one way to narrow it down. Seattle does have a lot going for it. Also good feedback on the non-performing loans, though I do think there will be some earlier opportunities to refinance bridge loans that sponsors are stuck with.
    Kris Patel Investor from Arroyo Grande, California
    Replied 4 months ago
    As a retiree, like drug store and student housing. First Corporate guarantee for 25 yrs, Second guaranteed by parents. Have both and happy.
    Sam Turgeon Real Estate Broker from Zephyrhills, FL
    Replied 4 months ago
    I'm interested to see how student housing weathers the storm. I'm not bullish on student housing. Academia is about to undergo some significant and permanent structural changes. I hope it works out for you.
    Phil McAlister Specialist from Chicago, IL
    Replied 4 months ago
    We are actively involved in student housing. I can tell you that there are still a lot of questions about how things will re-open, how students and parents will feel about living in close proximity, and especially how foreign students, which tend to be many of the highest end renters, may think about getting educated abroad.
    Lee Fjord Rental Property Investor from Saint Louis, MO
    Replied 4 months ago
    Great Article!!! Thank you!!! I am buying in the $1-3mil range in the Midwest but am now considering opening up to new markets like Dallas, Atlanta, Houston, and OKC due to their good job growth.
    Phil McAlister Specialist from Chicago, IL
    Replied 4 months ago
    Thank you! I worry a little bit about OKC as a one-trick pony with energy, and Houston for the same reason, but to a lesser extent due to its size and more diversified economy recently.
    John-Patrick D. Bailey Insurance Agent from Dallas-Fort Worth, TX
    Replied 4 months ago
    Amazing article! There's so much information and it is very easy to read. Thank you Phil
    Eric Carr Real Estate Broker from Los Angeles, CA
    Replied 4 months ago
    Nice work! I am of the belief that we are less likely to recover in 2020 than not. Good strategies and things to think about here
    Derek Gibbs Real Estate Investor from Ann Arbor, MI
    Replied 4 months ago
    Phil, thanks for the article. We are in the $5-15 million range, B/C+ and have not seen much in the way of discounts yet. We were able to negotiate a 5% reduction on our latest deal but half of that was due to some neglected CapEx. Most markets we look in have shown steady collections and pricing has been maintained accordingly. I like the idea of becoming the bank and have thought of trying it on a smaller scale to start. Good luck.
    Phil McAlister Specialist from Chicago, IL
    Replied 4 months ago
    Thanks, Derek. This is really good feedback. I do worry about inflation in the longer term, which can crush lenders so if you do dip your toe in, think about shorter term, bridge-type loans or variable rate.
    Michelle F.
    Replied 4 months ago
    Any data on how gentrifying neighborhoods do in a recession? Particularly those in the early stages of gentrification when the recession starts?
    Phil McAlister Specialist from Chicago, IL
    Replied 4 months ago
    Tough question, not sure how to properly classify gentrification or to gather large scale data on that type of granularity. More generally speaking, gentrifying areas are usually doing so for one of 2 reasons. 1 - big cities like New York or Chicago are pushing people into new neighborhoods because of affordability problems. I personally don't like these markets, but certainly good investors can succeed there, and 2 - worse parts of great and growing MSAs are gentrifying simply due to attracting new people. That's the sweet spot IMHO.
    Scott Meyers Developer from Fishers, IN
    Replied 4 months ago
    Phil, thanks for the article. As a Self-Storage Investor, we've seen how recession resistant it has been for the past 3 recessions, outpacing All other asset classes in the process. Self-Storage historically has the lowest Loan losses and loan default rates across the spectrum of real estate - at rates that are 1/3 of those in multifamily, and a fraction of those in Assisted Living, Hospitality, Medical, and Office rates. We don't celebrate a recession, but we've been preparing for the past 10 years and taking full advantage of the gift that the market gives to the Self Storage Sector in a Downturn.
    Tomer Versano Investor
    Replied 4 months ago
    Great piece. Thanks, Phil!!