Recession Proofing Your CRE Portfolio
With the Fed recently approving an interest rate increase of 0.75 and more increases expected this year in an effort to tamp down inflation, all signs would indicate that the US economy is headed for a recession. In fact, some would argue that we are already in a recession based on the fact that the negative gross domestic product reported during the second quarter, by definition, indicates a recession is in place (two consecutive quarters of negative gdp). This volatility, combined with record commodity prices, a war with no end in sight, and a lingering pandemic are adding to the unease and indicate a market cooldown. So, what should companies or individuals do to prepare for a market contraction? Here are three tips to help every property owner:
Evaluate Needs vs. Wants
If leasing or selling a property, recognize that the broader economic turbulence will impact property valuations and costs. Houston’s commercial real estate market is certainly still hot; however, expectations should be managed and we should expect the market to cool down over the next 12 months. If investments or modifications to your property need to be made to attract more tenants, try and distinguish what is essential and what can wait. If selling, consider what would provide the most value at a reasonable cost to you. With interest rates increasing, access to capital and the ability to borrow comes at a steeper cost. Construction costs, shipping delays and lack of subcontractors have also posed significant challenges these last two years. Any investment or modification to a property may not play out in your favor and careful consideration should be given prior to any investment.
Reevaluate your Portfolio
Now is the perfect time to review your portfolio’s financial position and consider liquidating non-performing assets. In any season, cash is king, and divesting a property now could help you preserve cash in the near term. By doing so, an opportunity to snap up a new investment when market conditions improve and interest rates decrease could also present itself.
In evaluating your portfolio, always pay attention to market fundamentals, such as property location and building specialties. Buildings that are more generic, have the ability to be subdivided, and appeal to a broader audience, will always be easier to sell or lease out. Properties that are highly specialized or customized may sit idle for longer periods of time because the buyer pool is smaller.
Carefully Review Tenant Evaluations
After losing so many tenants to work-from-home situations during the pandemic, it’s been a pleasant surprise to see companies and employees returning to an office format. Unfortunately, this may not last thanks to rising gas prices, increased crime in large metropolitan areas and other inflationary adjustments. Even with lucrative deals to fill vacant space, landlords should carefully vet each and every applicant, including the credit worthiness of tenants. While ‘a bird in the hand is worth two in the bush’, if a new tenant can’t pay their rent long-term, you could be exposing yourself to additional risk that you’re trying to avoid in the next few years.
Other key considerations
While the pandemic has helped and hurt a variety of industries and companies, it’s important to have an understanding of where each of your tenant’s financials sit. Pay attention to letters of credit and insurance clauses so you’re protected in the event rent can’t be paid. Also know when a client’s business loan term is up to protect yourself from a high risk tenant.
Consider negotiating leases today that aren’t up for another nine months. Perhaps a break on rent can be provided today, and you’ll be able to recoup any losses further down the road, if needed.
Most importantly, be wary with inflation and don’t get yourself in a bind. While a safer bet in commercial real estate would traditionally be a longer lease, inflation could outpace rent growth for the foreseeable future. Consider opting for a shorter rental term that allows you to increase the rental rates once market grows to meet the higher costs.
Overall, the risks associated with a down market are often mitigated by making sound choices in your investments. Real estate will remain a great investment as it can be used as a hedge against inflation. Bottom line, if you remain focused on properties with good fundamentals, you should be fine in just about any situation.
Have additional questions about recession proofing your commercial real estate portfolio? Connect with one of our professionals here.
Lee & Associates - Houston is a fully-integrated, commercial real estate company. Our business-minded brokers specialize in office, industrial and land real estate investments. As the fastest-growing, broker-owned firm in the nation, we are uniquely qualified to support our clients’ needs in the local, national and international markets. To learn more visit www.lee-associates.com/houston.