Rising interest rates, inflation, layoffs, small business closures, declining home prices, stock market woes and a looming recession are all here! How do you navigate this environment and capitalize on the economic storm with commercial real estate?
The 4 Most Dangerous Words in Real Estate Investing
“This time it's different.”
I have been through three up and down periods and recessions as a commercial real estate investor, and I can assure you that these are the four most dangerous words. “This time it’s different” is a false statement. The coming economic storm is not different. The symptoms may be different, but the results will be the same. Some people will fail drastically, and others will prosper. This is because there are four guiding principles that never change. Those investors who follow the guiding principles prosper and those who do not end up failing. These are four guiding principles will never expire no matter where you are in this economic downturn.
4 Guiding Principles that Never Expire
Always Buy on Cash Flow: Commercial estate is a cash flow business. This is one of the basic principles of commercial real estate that we teach our Protégé Program students.
Minimize Your Speculation: These days with a looming recession, job layoffs and high inflation, there's no room for speculation.
Be a Good Operator: As a commercial real estate investor, you need to understand and excel at the business of managing the property. If you have a property manager, like most of our protégé students, you need to learn how to manage the property manager. This takes skill, it's almost a science and you can't learn it on YouTube.
Do Not Over-leverage: This seems obvious, but you will be surprised how many still do this today.
Get Cycle Tested Advice
The first step in navigating and capitalizing on what’s coming is to get cycle-tested advice. Real estate is a cycle and there are four phases to every real estate cycle. To help you navigate these upcoming troubled waters, you need to get advice from someone who has experience through the entire cycle. If you have an advisor that has not experienced the full cycle, be very leery of that mentor.
This phase is a buyer’s market. If you recall, in 2008 to 2012, we were recovering as a country. You should have bought then. Yes, it was scary, but prices have doubled, sometimes tripled for investors who bought during this phase.
This phase is a seller’s market, and it is what we have been experiencing since 2012. For the last 10 years, we've been expanding, and sellers have been commanding high prices, and as investors we’ve been paying them because prices continued to climb.
After the expansion phase, we enter what is called a balanced market. I believe that we're about to make the turn into the recession phase of this real estate cycle. The average person would argue that since we are coming out of a seller’s market it only makes sense that phase 3 would be a buyer’s market. This is a false perception. It is not a buyer’s market, instead it's what we call a balanced market. Here’s why:
Lately investors have been making offers below the asking price because interest rates are high. High interest rates reduce the properties cash flow, making the high asking price unaffordable. At the same time, sellers are still anticipating a high price. So, between what the buyer offers, and what the seller wants there is a gap. That is called a balanced market and it is tricky to navigate. But guess what? The four guiding principles still apply here; buy on cash flow, don’t speculate, be a good operator and don't over leverage.
We are at a critical time in this phase, and you need to be extremely careful who you take advice from at this point. If you are working with someone who has only experienced the Expansion Phase as an investor, they won’t have the experience to give time tested advice on how to navigate in a recession phase. At Commercial Property Advisors we have experienced times of economic downturns and know how to guide you through this phase of the real estate cycle with real-world, time-tested mentorship.
Excess Supply Phase:
Once you get past the recession phase, we enter the excess supply phase which is a buyer's market.
3 Key Commercial Real Estate Niches
These are the three property types I recommend for commercial investors to capitalize on the coming economic storm.
Apartments are the obvious choice here due to increased interest rates and out of control inflation. We will look back on this year, as the year the feds created the biggest rental boom in American history. I already see it, and I think next year is going to get even better for apartment investors. Everyone needs a place to live, so apartments will be in high demand in the next few years.
2. Storage Facilities
This applies to self-storage, RV storage, and industrial warehouses. We love storage for various reasons, but the main reason is it does well in any economy. When the economy is doing well, people buy a lot of material possessions, and they need room to store it. And when the economy takes a downturn, people downsize, and they put their prized possessions into storage.
Some argue that in a recession people can't afford storage. I say yes, they can because storage is relatively inexpensive. One of our students bought a RV storage facility and he charges $125/month to store $275,000 RVs. Storage is very affordable.
3. Mobile Home Parks
One of the reason mobile home parks are such a good investment is because there is limited supply (there are very few new mobile home parks being built) and they are in high demand. Mobile home parks are affordable housing and right now we have an affordable housing shortage in America. With the looming economic crisis there will be even greater demand for mobile home parks.
Further teaching on these 3 key commercial real estate niches:
3 Must Have Strategies
When investing in these 3 commercial real estate niches, there are some strategies you need to implement that will help you navigate the stormy economic waters ahead.
1. Conservative Underwriting
Underwriting is how you evaluate the risk and potential returns of a commercial deal. It is a tool used to determine the value of a property and calculate cash flow. In times of economic uncertainty, when you evaluate a commercial deal, you need to implement conservative underwriting. With a looming recession, risks go up, so your cash flow projections need to be conservative. If you think that in the next five years you will be able to increase rents by "X" amount, you may want to temper those projections just to be conservative.
Also, your ROI expectations need to be tempered too. Last year we were paying 3.79% interest rates and now we're paying 6%+, by the end of this year we could be paying 7%. The interest rates went up but rent rates stayed fairly stable, so ROI expectations need to be tempered a little.
2. Loan Balloon
The second must-have strategy concerns your loan balloon date. When you purchase residential real estate, you can get 30-year fixed loan. So, you lock in your interest rate for 30 years which is fantastic. Unfortunately, with commercial real estate loans usually your interest rate is only locked in for 5, 7, 10 or 12 years and amortized over 30 years. That means in those 5, 7, 10, 12 years, we will need to get a new loan.
If you get a new commercial loan and it balloons in five years, and we are still in an economic downturn with high interest rates, where does that leave you? Will the numbers still work? It may get messy so it's best to have a loan with at least a seven-year expiration or longer. The longer you can get locked in the better. To help you navigate and capitalize on the economic storm I recommend a seven year or longer commercial loan.
3. Exit Strategy
This is so important and very few commercial real estate investors and mentors talk about it. At Commercial Property Advisors we excel at helping our students design strategies for exiting their commercial projects. Now, when we enter an economic storm and things get volatile, you need to have more than one exit strategy. You may plan to hold your property for seven years, sell it and exchange it for a larger property or maybe you want to do a cash-out refi in three years, pull all my money out, pay the investors back, and buy another one. That may all change with what's coming. It’s important to plan, but you need more than one plan.
Predicting the Future
A crucial aspect in planning your exit strategy is “it must be crafted by one who can see the future”. When I was an engineer, I had a mentor named Nick. He was an incredible guy- old Japanese, gray haired guy, with a cool beard- and he would predict what was about to happen in the technology sector we worked in. I remember thinking, "No way. That's just too far out there, Nick. It's not going to happen." But guess what? It happened; in fact, he made several predictions that came true in my decades of working with him. He could predict the future because he had been in the business for 30 years. As a young engineer, all I could see was what was happening at the time, but his decades of experience helped him see where the market was going, and he was spot on.
In the same way, your exit strategies must be crafted by one who can see the future. It takes scars to be able to craft an exit strategy that will make money down the road. At CPA we use our skill and experience to help our students see the future.