The real estate market is flourishing, and it seems like everyone is doing well. Bankruptcies are scarce, especially in the multifamily space. But this heaven won’t last forever. We are in one of the longest economy cycle, and even though nobody knows when it will shift, it’s important to be buy the right investment; one that will be solid during recession. The market is very forgiving right now, but there are several ways to make sure your investment -whether you are an active or a passive investor – will still be solid when the market turns.
Here’s how to make sure your investment is recession proof:
Don’t bank on appreciation, focus on cash flow I wrote about the weight of appreciation in calculating future returns for a real estate investment. When looking at the potential returns, pay close attention to the appreciation factor, which has a significant impact on your investment. The problem is that appreciation is an educated guess – you can’t know for sure how much your property will appreciate in the future, and when the economy shifts – it’ll be harder to sell at a profit; there will be fewer buyers in the market, because many lost money and lenders are striker with loans. That’s exactly what happened in 2008. So an investment that looks promising with a high appreciation factor might turn to be a losing deal if you need to sell it in a bad economy.
However, a conservative approach can show you if your investment is solid. When factoring appreciation, for an exit cap (the cap rate your property will be sold to a new buyer), I use cap rate that is 0.5% to 1% HIGHER than the cap rate I purchased the property with. A higher cap rate means a lower purchase price. Basically, I am assuming we will be in a down market when I need to sell (in 5-7 years from now). This approach is supported by economists projections that show increasing cap rates in the future. If your investment still shows good returns even if you sell it in a down market – than you are most likely to do well during a recession. This way, you are focused don the cash flow that the property is generating and not the future appreciation, which is not entirely known with high level of certainty.
Actionable advice for passive investors: ask the syndicator to share their exit cap assumptions and the purchase cap rate and compare the two – if the exit cap is higher or equal to the purchase cap, ask them why and use your knowledge of the market and your judgment to determine if it make sense.
Look at worse-case scenario - 0% rent increase
A significant part of any real estate deal, especially multifamily and office space, is rent increase. In a turn key deal, where no improvement to the property is needed, there is a certain rent increase that reflects the market trend, and is usually 2%-4%. That is to say, that the investor believes that because rents increase in the market, s/he will be able to do so as well. Some markets have a phenomenal rent increase, such as Orlando (with around 7% rent increase compared to last year). In a value add deal, the rent increase is projected based on investors assumption of post-renovation rent bumps. A rent bump of $75 - $150 per unit per month is pretty common with multifamily properties.
Rent increase significantly affects the projected returns of any deal. However, you should consider a scenario where rents have peaked and will no longer increase, which is a likely scenario in a recession. I believe this will be a harsh reality for many investors, and especially since we already started seeing a decline in rent growth across the US. A recession-proof property is one that is still cash flowing even when the rents are steady. When my team analyzes a deal, they run multiple scenarios, including a scenario where rent growth = 0%. It’s important for me to see how lack of rent growth affects the returns, and if it's still positive, then I know it is a good investment.
Actionable advice for passive investors: ask the syndicator for a sensitivity analysis with 0% rent growth and observe the returns in such case.
Look at the history – how did the area and the property perform in 2008?
Nobody knows how the next recession is going to look like, and hopefully the next part of the cycle will not be a sever as the previous recession, but looking into the history books of any investment will give us a better idea of how it will behave in the future.
Actionable advice for passive investors: before investing in a certain area, look up for information about how it during 2008 (even a Google search will be helpful). In addition, try to understand how the property performed during 2008; ask the syndicator what s/he knows about the property’s performance back in 2008 and ask to see financial reports from that period. You don’t have to be an expert to notice a loss in a P&L, and it’s important to inquire about it before you make a decision to invest.
In order to ensure your investment is recession-proof, make sure that:
- cash flow is impacting the returns, not a high appreciation factor
- the investment is still solid even with no rent growth
- the property was performing well even during the last recession
About the author
Ellie is the founder of Blue Lake Capital LLC, a real estate company specializes is multifamily investing throughout the United States. She is also the host of a weekly podcast called "That REllie Happened?! Unbelievable Real Estate Stories with Ellie". She started her career as a commercial real estate lawyer, leading real estate transactions for Israel’s largest development company. Later, as a property manager for Israel’s largest energy company, she oversaw properties worth over $100,000,000. Ellie is an experienced entrepreneur who helped build and scale companies by improving their business operations. She graduated from the MBA program at MIT Sloan School of Management and holds Masters in Law from Bar-Ilan University in Israel.