Seven Tips to Weather the Storm: A Recession Readiness Guide for Real Estate Companies
September 12, 2022
By Joseph Rubin
Today economists are not only debating how long inflation will last and what the Federal Reserve will do to combat it but also whether we will be or are already in a recession. Nearly all periods of monetary tightening have been followed by recessions, and some leading indicators—such as the University of Michigan Consumer Confidence Index—fell to an all-time low in June. Yet, consumer spending is still strong, and the job market remains robust. Whether or not the economy continues to shrink this year or next, the combined impact of rising inflation, increasing interest rates and a potentially severely slowing economy is shifting the real estate cycle. Property owners need to prepare now for a new investment and operating environment.
The current conundrum for the real estate investment community is that yields may fall even though properties are generating significant cash flow. Apart from the office sector, most properties and markets are experiencing continued tenant demand and rising rents, albeit slower than in prior quarters. But we are suddenly operating in a higher long-term interest rate regime that is lifting the cost of capital in a heavily leveraged business. Capitalization rates, despite some cushion from continuing liquidity, will have to rise. That means asset values will have to fall. Until the dust settles and market participants become accustomed to the new variables in computing yields, investors and operators will deal with uncertainty and change.
Whether you are leading a family business, private equity fund or individual real estate deal syndications, the following seven steps can not only prepare your company for the turbulence ahead but enhance longer-term analytics, reporting and decision making.
- Refresh Your Investment Strategy – Real estate is a local business, and supply and demand dynamics are very market specific. The path of growth has shifted from many gateway cities to secondary cities in Sun Belt and Mountain states. Property type performance has also varied: multifamily, industrial and self-storage are in continued growth mode; hotels are rapidly recovering but more vulnerable to recessions; retail is holding its own; and office is likely to see a significant reduction in demand. Inflation has upended the traditional preference for long-term leases. In periods of change, capital is often reallocated to more predictable cash flow and investment returns or to distressed opportunities. Accordingly, real estate companies must take a fresh look at their investment strategies and rebalance their portfolios among markets; asset types; and core, value-add and opportunistic targets. Given the likelihood of higher cap rates, management may accelerate the disposition of certain investments that have already reached their potential value or have the potential to lose value during the remainder of the intended holding period. Now is the right time for management to make an honest assessment of the competitiveness of their assets, given changing tenant preferences and requirements. In down cycles the highest quality properties win, and today quality is defined by design, amenities, and environmental and wellness considerations. Downturns are often the best time to reposition properties and prepare for an upswing.
- More Closely Monitor Portfolio Performance – Periods of volatility and higher risk require laser focus on property performance. Management needs real-time updates on leasing and monthly property operations to implement strategy refinements in response to the new interest rate and economic environment. The priority is receiving timely, actionable data. Accordingly, real estate companies should re-evaluate the adequacy of their systems to collect and analyze the key performance indicators for each investment, and the frequency and format in which that information is reported. Key indicators may include trends in net effective rents, required concessions, downtime between leases and the impact of inflation on various categories of operating costs. Tracking the health of markets and tenants is also critical to understanding emerging trends, and there are now many new sources of data to enhance analytics. Design dashboards to highlight key changes to revenue and expenses so that management can quickly identify and react to performance trends, particularly for transitional properties more vulnerable to changes in demand.
- Manage Your Costs – Both operating and capital expenses are rising with inflation, eroding net operating income and net cash flow. Early in the pandemic, many real estate businesses worked to reduce the costs of running their properties. Given new increases in utility, supplies and labor costs a refresh of that effort is warranted. A key component is vendor management: review contracts for goods and services, evaluate vendor performance, and potentially renegotiate contracts or put contracts out for bid. Management can also analyze property-specific versus portfolio bulk purchasing to assess potential savings and consider centralizing purchasing. Fraud is an ever-present risk in real estate businesses. All real estate operators should periodically evaluate the adequacy of internal controls around vendor selection and performance management, as well as the accounts payable and treasury functions.
- Review Your Mortgage Loans – The rapid rise in interest rates requires real estate companies to review their debt, particularly those loans with near-term maturities or for deals where the sponsor was intending to refinance a rehabilitated property and return partial capital to investors. The first step is to inventory the mortgages that mature in the next 18 months and compare the contractual interest rates to current rates. Management must also understand prepayment penalty clauses in the analysis of refinancing early or waiting until maturity. In any financing of new acquisitions or refinancing of existing debt, the decision to choose fixed- or floating-rate payments is far more complex and depends on the company’s outlook for rates, their investment horizon, the need for prepayment flexibility and the cost of hedging the floating rate option. The other key variable is proceeds. Lenders have recently tightened underwriting, lowering leverage and raising debt coverage requirements, often resulting in less debt at a higher price. Given the significant increase in property values during the past few years, there may be an opportunity to take cash out of the deal and use it to implement new strategies, make existing properties more competitive or defray increasing costs.
- Update Your Investment Models – Based on the analysis of the properties and related debt, investors can update their deal models to identify variances in expected cash flow and exit price. Projected revenues and expenses for the intended life of the deal can be refined based on leasing trends, inflation expectations and cost management. The model should also reflect newly estimated amounts and expected timing of capital expenditures. Estimating disposition value is difficult given the current lack of price discovery. One approach is to probability weight a range of capitalization rates to derive anticipated value at exit. The models will provide management with updated yield expectations as well as the possible impact on deals. By frequently revising deal models based on more reliable market and property performance data, investors can establish hurdles to trigger asset management strategies, including refinancing and selling the properties.
- Tighten Cash Controls – Despite inflation, prudent investment managers hold cash in periods of higher risk. For certain properties, the combination of weakened demand and higher operating and funding costs may increase the need for cash. Real estate companies should consider projecting cash needs on a detailed basis for the next quarter and a higher-level basis for the next 12 months. Cash projections are different than operating budgets and are particularly relevant for funds and family businesses where the cash flow from various investments may be comingled. Even if there are no immediate issues, rolling up the cash available from multiple assets in a portfolio into a single view of cash availability for investments, capital expenditures and distributions will provide insight as the company navigates the next 18 to 24 months.
- Enhance Communication with Stakeholders – Communication with stakeholders (e.g., investors, employees, lenders, vendors) is more critical in times of uncertainty to avoid surprises and potential conflicts. This is especially true when there may be less cash to distribute to family members and investors. Additional and more detailed reporting is often warranted. If loans have maturities within the next 12 months, early conversations with lenders to inform them of current and expected property performance will not only be appreciated by the lender but also provide the real estate owner with the current trends in debt terms.
The enhanced strategies, analytics and communication each of these seven steps provides will help real estate businesses respond quickly to evolving trends in the capital markets, the local property markets and asset performance. We are entering a new environment of higher interest rates, operating costs and the probability of recession. As the Federal Reserve reduces its balance sheet and fixed-income securities gain attractiveness, the real estate investment sector might lose some of the extraordinary liquidity that has sustained its growth for the past 15 years. These cyclical shifts will likely result in some distress but also offer opportunities. Optimizing the performance of existing holdings, recalibrating investment and asset management strategies, and reallocating capital to implement those strategies will buffer the industry from the impact of a potential economic downturn.