Six Considerations for Commercial Real Estate Investors Facing Uncertain Market Conditions

In 2015, Sam Zell, founder and chairman of Equity International, sold his multifamily portfolio of more than 23,000 apartments for $5.3 billion. At the time, many industry insiders thought that Zell had sold at the top of the market – just as he had sold his office portfolio in 2007 before the market crashed.¹ While Zell walked away from the deal with plenty of profit, multifamily prices have continued to rise – meaning that he could have done even better if he held on.

Fast forward to 2019 and the U.S. economy is still in the midst of the second-longest economic expansion in history. During this economic upturn, investors have witnessed all three major stock indexes at least quadruple in value at one point. But all good things are bound to come to an end – eventually.

While the fundamentals of the economy are still relatively strong, there are some indications that the inevitable cyclical slowdown is around the corner. Indeed, murmurs of a recession are now bubbling to the top. Consider the following:

• Foreign investment in U.S. commercial real estate plunged in the first half of 2019 as signs of a global economic slowdown made buyers more cautious. In fact, the slowing economy and uncertainty over where U.S. interest rates were headed have caused many overseas investors to hesitate on deals, according to Spencer Levy, chairman of Americas research for CBRE.²
  New York City’s condo market is struggling. About one in four new condo units constructed since 2013 are unsold. And, of the units that did trade, about 30% are on the market as rentals, according to a StreetEasy analysis published by September of 2019.³
• The Federal Reserve cut its benchmark interest rate by a quarter point. St. Louis Federal Reserve Bank President James Bullard said he argued for a deeper rate cut than his colleagues approved because he fears that the economy is slowing and manufacturing “already appears in recession.”⁴
• Duke University’s Fugua Business School reported that almost half (48.6%) of surveyed U.S. CFOs expect a recession by the end of 2019 while 86% expect a recession in 2020.⁵

Staying in the game

The potential slow down, however, doesn’t mean that commercial real estate investors need to throw in the towel. As a commercial real estate investor, however, you might need to play the game differently. To succeed in an uncertain environment, it’s important to:

#1: Take a more defensive approach. While there are still plenty of opportunities for commercial real estate investors, it’s time to take a more defensive posture. It’s important to remember that the opportunity to see aggressive returns is no longer a sure thing — at least not without a corresponding increase in risk. As such, you need to pay considerable attention to downside risk.

#2: Know your risk profile. Investors can still succeed even if markets are about to take a turn for the worse. The key is to understand what your risk tolerance as an investor is. Remember, the margin for error in an uncertain economy is significantly tighter – so you need to proceed carefully and strategically.

#3: Determine what capital is best. Debt capital, which refers to borrowed funds that must be repaid at a later date, and equity capital, which refers to funds invested by shareholders, are both viable options. While debt capital is generally less expensive than equity capital and won’t dilute ownership, investors need to consider which type of capital to tap into on a case-by-case basis. Perhaps most importantly, as an investor, you need to understand where you are on the credit spectrum and know what amount of debt is sustainable and reasonable. A reasonable amount of debt will support your investment thesis and the timing of the hold. An unreasonable debt investment could put your operating business under pressure due to capital markets activities.

#4: Proceed with caution. In a strong economy, investors don’t have to get everything just right to turn a respectable profit. As the economy shows sign of slowing down, though, it’s critically important that you understand and pay attention to the details that can impact the cash flow and value of each investment. .

#5: Pick partners carefully. Working with lenders and limited partner (LP) investors that have domain expertise is a must. Make sure your partners have what it takes to succeed in the particular market and/or asset class that you are investing in. If partners have the right tactical and operational experience, they will be much more likely to understand issues that arise, and that will enable you to manage investments more successfully.

#6: Avoid a cookie cutter approach. Investments need to be analyzed and executed on a case by case basis. One size doesn’t fit all – especially in an economy that could present challenges. Remember, every individual market and every individual building has different, unique challenges. So, as an investor, you need to understand the nuances of a neighborhood, a development or a building. Indeed, it’s important to understand the tenant mix, the unit configurations and the unit layouts to come up with that unique strategy that works.

By acknowledging that the economy could take a turn for the worse and adopting these more defensive strategies, commercial real estate investors can enter into the agreements that will ultimately result in success.

References
¹Petra, R. The U.S. Commercial Real Estate Market Remains Strong Despite Global Economic Concerns. National Real Estate Investor. https://www.nreionline.com/finance-investment/us-commercial-real-estate-market-remains-strong-despite-global-economic-concerns
²Wong, N. Foreign Investment in U.S. Commercial Property Drops Almost 50%. Bloomberg. https://www.bloomberg.com/news/articles/2019-09-09/foreign-investment-in-u-s-commercial-property-drops-almost-50.
³Long, G. NYC”s Unsold Condos: Thousands of Units Linger on the Market as More are Built. https://streeteasy.com/blog/nycs-unsold-condos/
⁴Cox, J. and Cullen, T. The Federal Reserve is increasingly divided with one official even wanting a sizable half-point cut. CNBC. https://www.cnbc.com/2019/09/20/feds-james-bullard-says-cutting-rates-by-a-bigger-half-percentage-point-would-have-been-more-appropriate.html
⁵Duke FUQUA School of Business. CFO Survey: Recession Likely by Year-End 2019. https://www.fuqua.duke.edu/duke-fuqua-insights/cfo-survey-december-2018