There’s always talk of an economic downturn waiting to happen, along with threats of natural calamities, health crises, and even wars occurring. Although it is impossible to say when a market plunge will actually happen and the extent to which it will affect us, one thing is certain – we will reach a market correction or a recession at some point. And as a real estate investor, you will want to do everything you can to be prepared for the inevitable bottom-out of this boom and bust cycle and its effect on the real estate industry.
Michael Becker and I had a conversation about this not too long ago. Michael, principal at SPI Advisory LLC and an industry powerhouse with more than 6,000 units to his name, went through some weighty setbacks in recent times. The 2021 Texas freeze, the costliest winter storm on record, amidst a global health crisis tested his business mettle. A double whammy of a natural calamity and a pandemic bared how resilient his business was in the face of adversity.
I’d like to share some of the insights that Michael learned from those experiences. He touched on a few great things to consider in order to be prepared for an economic downturn. Click here if you want to hear our full conversation.
#1 Have a good management team
An excellent property management team is key to a successful multifamily operation and will keep your business going during hard times. “We made sure we had a proper management team in place. I felt really good that we were able to test the teams, and they handled setbacks really well,” says Michael about his team’s competent response to the calamity that befell their apartment rentals.
To be specific, his management teams were able to weather bad times through the following initiatives:
- Being proactive about rent collection
“They were extremely proactive, knocking on doors every day and continuing to collect payments,” tells Michael.
- Helping tenants access government rent assistance programs
Michael’s team proactively helped residents who struggled with payments to avail of rent payment plans extended by the state and local rent relief programs.
- Putting up a rent relief fund
“My former partner and I set up a rent relief fund and we probably put up, $70,000 of our own money, and then we had some of our best sellers pitch into that. We helped keep some of these residents that otherwise are good tenants but they just hit a little hard spot. The fund helped those people get through it for a few months,” Michael says.
#2 Fixed-Rate vs. Adjustable-Rate Mortgage?
When setting up your deal, which of the two main loan types will best suit your needs: fixed-rate mortgages or adjustable-rate mortgage (ARM)? A fixed-rate mortgage charges a set rate of interest that remains unchanged throughout the life of the loan, while the interest rate for an adjustable-rate mortgage is variable, with the initial interest rate set below the market rate and then rising as time goes on.
“Generally, if you’re in a recession, the Fed is going to cut rates. They don’t really raise rates in economic stress, they raise rates when the economy is going well and booming. So
if you hit a recession, it’s better to have an adjustable-rate mortgage, because, in theory, you should see rate cuts and see some debt-payment relief,” explains Michael.
He adds that when they first started, most deals were structured with fixed-rate mortgages which turned out unfavorable to them when the rates went down. “Our adjustable-rate mortgages, those deals really shined the last 12 months,” he says.
However, he cautions that when choosing a mortgage, you should consider other factors and balance them with economic aspects in a market that is constantly changing. So, not only must you look at interest rates and current market trends but also consider the following: (1) maximum mortgage payment you can afford today, (2) whether you could still afford an ARM if interest rates rise, (3) how long you intend to pay for your loan. Run the numbers to determine the worst-case scenario if you’re considering ARM. If you think you can still afford it if the mortgage resets to the maximum cap in the future, an ARM may be favorable for you.
#3 Do not over-leverage
Taking on debt is a major means for syndications to raise capital. When managed efficiently, borrowed money enables companies to purchase properties, upgrade facilities, and scale business. However, when you borrow too much, you become vulnerable during a recession and you run the risk of becoming bankrupt.
Overleveraging or taking on too much debt puts your company’s finances at risk during a recession because a major portion of your cash flow, which may be negatively affected, will be used for debt payments and you may not have much money left to run your business.
“A company that is less leveraged can be in a better position to endure an economic downturn and drops in profits because they do not have too much burden on their cash flow. So, in a situation where a recession is likely, you should reduce your debt,” advises Michael.
#4 Have a proper working capital
Having a surplus of cash on hand is crucial in an uninterrupted business operation during an economic decline – especially if you unexpectedly suffer a loss of income.“Every deal we do now, we come in with an abundance of working capital so we have enough money to do everything we plan to do plus some “just-in-case” money for unexpected events like the power grid shut down for two days in Texas in the middle of a cold snap,” Michael explains.
He suggests setting up a self-escrow CapEx account with the lender to hold funds that you will use for unexpected circumstances in addition to the capital expenditure budget rolled in the loan. “Usually, we try to plug in $100,000 at a minimum, and then on top of that, usually we roll in around $300,000 depending on the size of the deal. I guess if that’s a smaller deal, you may be cut that down.”
Michael emphasizes the importance of building up robust working capital to sustain business under an economic dip, citing the following strategies that his company practices to pad their reserves – “We get that first round of collections where we don’t really have a lot of expenses, then, usually we wait two to three months before we start up distributions so we’re getting some additional working capital. It’s retaining the free cash flow.”
#5 Good location
“Location is always something I was really particular about with our investments,” says Michael. He adds that the small delinquency issues they encountered during the pandemic were more concentrated within the workforce housing. While there was rent relief assistance extended by the government, it is still wise to consider investing in neighborhoods in economically diverse markets to minimize the negative effects when a market turns.
Final Thoughts
While I always say that no one has a crystal ball and no one can tell precisely when the market will crash, we should be preparing as if it’s coming on the horizon. Although nothing is truly recession-proof, there are asset classes – such as multifamily housing – that not only allow you to grow your wealth over time but also give you the safest investment bet to get you through a recession.
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