What are the challenges of being an investor in a recession?

[John Hewitt]

This may seem like a noobie question, but I’m looking for some in depth answers. I’m wondering how a recession affects various aspects of commercial real estate, specifically multifamily properties. I understand investing during a recession can be a challenge and has caused many people to go under. Why is this? How can you protect yourself and investments during a recession? Can a recession be an opportunity for some investors to buy or is it a time to hold on to your money?

Feel free to add anything that you feel fit. Thanks.

[Nick Schoch]

What makes investing during a recession challenging? 

For one thing, capital availability. Lenders see increased risk in the market and either charge higher interest rates or, more likely, stop lending altogether. Recessions make it harder to fill vacancies in your properties and put downward pressure on rental rates. This decreases your cash flow, which in addition to the obvious issue, also makes it harder to refinance if you happen to need to.

How can you protect yourself and investments during a recession?

Use leverage (debt) responsibly. 

Let's use an example:

• Purchase. You purchase a 10-unit property. The units rent for an average of $1,000/unit/month. You assume 5% vacancy and a 40% expense ratio. Your NOI is $68,400/year. Using a 6% cap rate, your direct cap. value is $1,140,000 ($68,400/6%). You finance the property with 25% down, resulting in a loan amount of $855,000. The interest rate is fixed at 5% until maturity in 5-years and the loan amortizes over 30-years. The LTV is 75% and the Debt Service Coverage Ratio is 1.24x. You're happy and looking forward to your future sipping Mai Tais on the beach.
• Recession hits 4-years later. It's time to refinance since your loan matures this year. Unfortunately, the market is soft due to the recession. Rents have decreased about 5% in your market since purchase, resulting in an average unit rent of $950/mo. You followed the market down to maintain average occupancy of 95%. You keep your tenants on 6-12 month leases because you're confident this is a temporary dip and rents will recover when the market stabilizes. Cap rates have increased 50 bps to about 6.50%. Holding your operating expense estimate constant at 40%, your annual NOI is $64,980, resulting in a direct cap. value of $1,000,000. Over the past 4-years, your loan has amortized down to $800,000. Your current LTV is 80%. This is above your lenders maximum LTV of 75%. To refinance with this lender, you will have to remargin (pay down) the loan by $50,000.
  Will you have this $50,000 in the depth of a recession? 

I worked out troubled commercial real estate loans during the last downturn. Bullet/balloon maturities were usually what caused borrowers trouble during a recession. The best positioned borrowers were those that didn't have high leverage to begin with or those investors that had loans with no covenants and no maturities during the recession. If you have a portfolio, it helps to stagger loan maturities.

Do recessions provide opportunities to buy?

Absolutely, if you can. As mentioned in the example above, property prices generally decrease in a recession. This provides a buying opportunity. The hard part is timing the market so that you have cash available to buy properties, especially at a time when most lenders step out of the market or require onerous down payments.