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

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

7 min read
Phil McAlister

Phil is the founder of The Macro Meets Real Estate Newsletter, a refreshing and entertaining take on real estate investing and financial markets.

A Chicago-area native and real estate investor, Phil’s career has spanned investment banking, commercial lending, and real estate, with extensive transaction experience from multiple sides of a deal.

Experience

Working for a large national sponsor, Phil has been in charge of the underwriting, financial modeling, and valuation of over $6 billion in commercial real estate, including multifamily, medical office, self-storage, hospitality, and senior housing assets. Phil leads a team in evaluating commercial real estate deals nationwide and across multiple strategies including core, core-plus, and value-add, with an occasional ground-up development sprinkled in.

Phil is also involved in evaluating and negotiating multi-million dollar joint ventures with various strategic partners. In addition, Phil has been tasked with evaluating projects in Qualified Opportunity Zones, a new and exciting frontier in commercial real estate.

Phil’s passions include family, football, American history, and real estate investing, in that order. Phil resides in Naperville, Ill., with his wife Kristin and three (sometimes) perfect children, Anna, Ryan and Charlie.

Phil holds a bachelor’s degree in finance and economics from Elmhurst College.

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

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.

construction-site-build-construction-work-159306

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.