What You (As A Passive Investor) Can Do To Protect Yourself In A Downturn
How you can protect yourself in a downturn is fundamental when it comes to investing!
Look … neither of us are idiots, and I won’t disrespect you by treating you like one.
“Real estate always gains value! It never goes down!”
We both know that’s a myth. Many of us are old enough to remember 2008, and for those of us who aren’t, the truth is only a Google search away.
The truth is this — real estate can and does lose value sometimes.
Over time, the market has trended upward. I still firmly believe that real estate is the most rock-solid millionaire-maker out of every asset class. From the cash flow to the tax advantages, you just can’t knock it out.
But over short periods of time, we have seen memorable downturns in the real estate market — often lagging just behind downturns in other capital markets, like stock markets. Yes, it has always rebounded … but it can take years, and those years can be tough. Investors caught unprepared can realize significant losses.
Let’s remind ourselves of Warren Buffett’s wise words…
Of course, every investment involves risk. You can’t just stuff your money in a mattress — that’s a guaranteed way to become less wealthy. You’ve seen the inflation numbers, so you know I’m right.
No, protecting yourself from a downturn as a passive investor involves being very selective about the deals you enter when you smell a turn in the market.
I’m about to share with you what to look for in a passive commercial real estate investment to protect your ass if the market takes a turn for the worse.
These are essential tips for weathering the periodic recessions and depressions that characterize our economy … but they’re not bad advice for any time you invest.
When you’re managing your risk properly, you should make every investment under the assumption that the market could experience a downturn.
If a downturn would wipe out the investment in a matter of months, consider carefully whether or not you want to make that investment — especially a passive investment. If you invest passively and the market spirals, there’s not much you can do to right the ship. You’re in the hands of the deal sponsor, for better or for worse.
So passive investors, prepare yourself! Here’s what to do to protect your passive investing strategy in the event of a downturn:
1. Protect Yourself In A Downturn – Look For Cash Flow Early On
Cash flow is king in so many ways, but never more so than when investing in real estate.
It’s security. Cash flow is protection and will save your ass when a recession puts everybody else’s ass in a sling.
A property that produces cash flow on Day 1 or within the first quarter after closing is much more likely to survive a downturn than a deal that banks on cash flow a few years down the road.
With positive cash flow early on, who cares if the property takes a dip in value? The bills are paid — including, most importantly, the debt service, which is how you stay current on your loan and avoid foreclosure.
Compare this situation to a ground-up development project. Yes, the projected returns on those deals are fantastic. If they go swimmingly, the investors are in the money.
But if the economy tanks while development is underway, the deal could be in trouble. There could be construction delays. Material and labor costs could skyrocket. The project could stall halfway, uninhabitable with no way of generating cash flow … but those debt service payments are still due like clockwork.
And even if the ground-up development project does limp across the finish line, it may be worth less than anticipated and no longer qualify for a refinance into a long-term debt position, leaving the investor group stuck with a high-interest, short-term construction loan that can’t be easily retired.
Want to protect yourself from a downturn? “Cash flow early on” is your best friend.
2. Protect Yourself In A Downturn – Get Conservative
So many people talk about “conservative underwriting.” It’s an easy thing to say. It’s a buzzword. Passive investors love to hear it.
But then you look at their underwriting, and there’s nothing conservative about it. It’s like Inigo Montoya in The Princess Bride — “You keep using that word … I do not think it means what you think it means.”
The sad fact is that deal sponsors make their bones on hyping up real estate. They’re worse than REALTORs and brokers in some way — they have to convince you that real estate always goes up. Otherwise, no one would buy!
So don’t get taken in by the razzle-dazzle. Skip the hype and go straight to the numbers. Did the sponsor and his team use the principles of conservative underwriting in their analysis? Things to look for include:
- Year 1 Rent Increases. Most investor groups buy property with the expectation that they can increase the rent. Maybe the rent is below market rates. With a little TLC (or a heavy renovation) that rent could be brought up to market rates. It’s very plausible.
But how long is it going to take? The process of turning, renovating, and releasing units can be lengthy and unpredictable. If a deal sponsor predicts a move from below-market rent to market rent within the first 6 months, for 100% of the tenants, I become very suspicious. That’s a sign of aggressive underwriting, and it’s the wrong choice for a downturn.
- Vacancy. Most property managers and real estate brokers will be able to tell you the local “market vacancy” — what percentage of the property’s maximum rent potential will be uncollectible due to vacancy. Unit turnover, unexpected repairs, etc.
But with “value-add” deals, it isn’t conservative to presume market vacancy — especially not in the first year. If your market has a 5-8% vacancy rate, look for a Year 1 vacancy several points higher, 10% or more. Don’t forget, vacancy is not the only reason rent might be uncollectible. There’s also tenant nonpayment, concessions, and discounts to get units rented quickly in a pinch.
An effective vacancy of 12% in the first year isn’t unreasonable. If the deal can’t survive that kind of vacancy, it is most definitely not recession-proof.
- Expense Decreases. If rapid increases in rental income arouse my Spidey Sense for danger, rapid decreases in expenses are an equally big red flag. I especially don’t want to see stable numbers for things like insurance, property taxes, and utilities, which tend to go up with time instead of down — especially in this day and age.
Another major culprit is a decrease in payroll. Whom do you expect to fire and replace with someone who will do a better job for less salary? Sounds a bit pie-in-the-sky.
If you see a big expense decrease, there should be a plausible justification. For example, replacing old toilets with low-flow toilets is a quick way to cut water utilities, without decreasing the bill-back to the tenants. But it’s not conservative to speculate lower expenses out of nowhere.
- Income-to-Expense Ratio. One quick-and-dirty way to tell whether or not you’re looking at a conservative underwrite is to calculate the income-to-expense ratio. Good deal sponsors will include this figure, but you may have to calculate it yourself by dividing the total expenses by the total income.
What am I looking for? For smaller properties, a ratio of about 50%. For larger properties (60+ units), a ratio of about 57%. If you see a number of 42% or lower, the underwriter is probably being too optimistic about how many expenses it will take to maintain the income projections. It’s just a rule of thumb — but a helpful one.
- Debt Assumptions. In an environment of rising interest rates, it’s more important than ever to be conservative with your assumptions about the debt terms that will be available to you. It may be tempting to use prevailing interest rates (or better yet, last year’s interest rates) on your underwriting assumptions … but until that rate gets locked, anything could happen. You could end up with a nasty surprise.
If you want to underwrite conservatively, use an interest rate at least a quarter-point, even half a point, above prevailing rates. Game both out and see how the deal fares.
- Exit Cap Rate. The exit cap rate is the plague of conservative underwriters. There’s always a temptation to use the prevailing cap rate for properties of this class — or at least the cap rate you purchased at. But in a downturn, cap rates will face upward pressure. You have to be prepared for the possibility of a lower cap rate at the sale.
If the deal sponsor didn’t do it for you, try applying a cap rate a quarter-point or higher and see what exit price you get. If the deal is gutted or a loss at that higher cap rate, exercise extreme caution.
Of course, a deal isn’t just numbers — it’s also a story. If the deal sponsor is credible, you don’t have to shut your ears to that story and cleave to “the numbers” with robotic servitude. But we’re talking about protecting yourself from a downturn. If the numbers contain red flags, the story had better be damn good.
3. Protect Yourself In A Downturn – Go With An Experienced Deal Sponsor
The final consideration to protect yourself from a market downturn as a passive investor is to carefully vet the deal sponsor. Unless it’s us. Just kidding. If you’re new to Investor Boardroom, I have every expectation that you’ll hold our feet to the fire — and I welcome it.
Once the deal is funded, it’s out of your hands and into the hands of the deal sponsor. You have to make sure it’s someone you trust.
Look carefully at their track record. How many deals have they done, and what were the results? Have they been successful with deals like this one in the past? Have they been through an economic downturn before? If so, how did they handle it, and what did they learn from that experience?
Good deals exist, even in a market that is peaking and ready to turn. An experienced deal sponsor has the expertise to recognize them — and the connections to find them in the first place. Experience sponsors may also be more trustworthy in the underwriting because he draws on what they know first-hand, not guesswork.
What About Deals I’m Already In? Can I Protect Those?
Not really. Like I said, once the passive investment is made, the die is cast. Maybe the deal sponsor will listen to your ideas of how to right a drifting ship, but most syndications don’t afford a whole lot of power to the passive investors. Besides, the deal sponsor is theoretically more experienced and more intimately involved in that deal, so there’s no guarantee that you know best compared to him.
If the market does turn and you’re in some passive deals, don’t panic. Real estate is resilient. Deal sponsors usually have several tricks up their sleeves to keep a deal alive under adverse conditions. All is not lost — keep the faith.
Market downturns are a reality — and they’re also a scary prospect, especially if you have never been through one with skin in the game. When the market takes a dip, the news will be filled with gloom and doom (to say nothing of social media).
I understand the urge to protect your principal at all costs … but remember, no one makes the big bucks without accepting some level of risk. The trick isn’t to avoid risks at all cost, but to manage them. This whole article has been an exercise in how to manage that risk.
Humans have short memories. We tend to think that current conditions will persist forever — which is why people always fall victim to the myth that real estate never loses value. Conversely, bad times can feel interminable, like they will never end.
But there’s a silver lining.
Downturns in the market are a great time to buy.
When prices are low, experienced groups like Investor Boardroom back up the truck and fill it up. That’s when the real fortunes get made.
Want to be shoulder-to-shoulder with us in the next buyer’s market? Contact Investor Boardroom today to talk about opportunities for passive investing in every market condition.
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All the Best,