The most recent economic downturns consisted of the Great Recession of 2007-2009, and the coronavirus-driven slump. The former was triggered by the housing market collapse, while the virus-induced quarantines were to blame for the 2020-2021 event. Regardless of the causes, both economic downturns resulted in a loss of jobs, a decline in consumer spending, and lower manufacturing output.
How do down cycles in the economy affect real estate investing? The answer depends on a multitude of factors.
CRE and investments
Overall, economic downturns have an impact on real estate occupier demand, construction, and investment. But the sector’s response can vary, due to the following.
Asset types. Not all real estate asset types are the same. Demand differs, based on occupier needs, supply, and location. Tenant demand for an office property differs from tenant demand for a senior housing center. For instance, during the 2007-2009 downturn, industrial and multi-family assets experienced low tenant demand, due, in part, to more supply and less competition. A decade later, however, occupier demand for both apartments and distribution centers was very high. This, in turn, has impacted property value and cap rates -- two metrics investors should study when it comes to portfolio improvements.
New construction. Even if demand is high for a particular real estate asset type, it’s possible that not enough supply would be built to meet that demand, for several reasons. Raw materials might not be as plentiful. Land could also be scarce, as landowners wait out the downturn, in hopes of better pricing when the economy improves. Another factor, especially during the COVID-19 downturn, involved scarcity of labor, due to quarantine issues. Less construction means less supply. And less supply can mean higher prices for investors -- assuming that owners want to sell properties, that is.
Financing. Real estate lenders are very cautious during downturns, whether the applicant is an investor or a builder. Financial institutions tend to prefer a higher equity involvement from the applicants. Lenders also want assurances that borrowers can pay loans without defaulting. As such, lenders during a recession might focus on real estate properties with regular cash flow, proven balance sheets, and strong tenant basis, versus value-add opportunities.
Location. Geography plays a large role when it comes to real estate, especially in light of downturns. This is because it’s rare that recessions have the same characteristics in all parts of the country. For instance, Texas weathered the Great Recession somewhat more effectively than did Arizona and Florida, primarily because of a more stable housing market in the Lone Star State. This meant that Texas commercial real estate was considered a less-risky investment than those in Arizona or Florida.
Investment issues to consider
When it comes to real estate investments during downturns, it’s a good idea to keep the following in mind.
Apartments, offices, or . . . ? Again, understanding asset type performance during a recession is important, depending on investment goals. Some real estate assets are recession-resilient, while others are not. Types of recession-resilient assets can include self-storage facilities, multi-family housing, and senior housing.
Holding periods. Longer holding periods -- such as those ranging from seven to 10 years -- can generally be more effective before and during a recession. Recessions rarely extend into years, meaning a hold might be successful in lasting out the downturn.
Available debt. It also can be a good idea to rely on longer-term, fixed-rate debt, versus interest-only mezzanine, or other short-term debt. A 7- to 10-year loan term, with a fixed rate, could outlast even the most stubborn recession.
Capital preservation. During an economic downturn, a good strategy could be a focus on capital preservation, versus capital expansion. As such, newer, well-tenanted, lower-risk properties might be a better addition to a portfolio, versus value-add opportunities.
It all depends
The commercial real estate sector is extremely broad, with many asset types. Additionally, commercial real estate is a highly geographic industry. These two reasons make it difficult to answer the question about how down cycles in the economy affect real estate investing.
To ensure the correct real estate addition to a portfolio, or as part of a strategy, investors must focus on due diligence and expert advice from a financial professional. Such activities can help ensure that the property real estate product will be used to meet investment goals.
