NOTE TO READERS: This article was published by National Mortgage News on August 29, 2019, and is reprinted here with permission from the publisher.
July 1, 2019, was an important date. Why? Because it marked the day the U.S. economy officially entered into the longest economic expansion in American history. And, while commercial real estate fundamentals remain very favorable, and debt and equity capital remains plentiful, one can’t help but feel that sneaking sensation that a recession is around the corner. A common question is: “When will the next downturn hit?” — but the more important question is: “When and how should I start preparing for it?” Many, including this author, believe the answer is now.
The second half of 2019 is a prudent time to examine the CRE market in the context of an inevitable slowdown, to take into account how the current landscape is impacting lending practices, and to prepare with the best risk management strategies. Making forward-thinking and fully informed property investment decisions will help mitigate any adverse impacts from future market ebb and flow — now is the time for recession preparedness.
Given the healthy market fundamentals, the consensus in the CRE world is that investors should keep investing in commercial properties. But it would be a mistake to throw caution to the wind and buy without thoroughly vetting opportunities in the context of the market cycle. At this late stage of the recovery, CRE prices are at their highest levels, especially in 2Q 2019, as inexpensive access to capital is fueling concerns of overpricing.
Deals are becoming more challenging the further we get into the cycle, and there are often more complex environmental issues that consultants need to highlight, analyze, and discuss with lender and investor clients. Add that to growing global economic and political concerns, domestic political risk and growing fears that a recession is around the corner, creating a reason to worry.
One very real risk is that buyers may pay peak prices late in this cycle — right before the recession strikes — making it difficult to realize a return on investment. Another concern is that investors are under pressure to place capital now while the market is still healthy and, coupled with intense competition for the good deals, it may be tempting to cut corners on robust due diligence.
There are strong reasons to keep your guard up. Stringent environmental due diligence is essential at this stage of the cycle — when prices are peaking in many metros — to ensure that a property is worth its asking price and that there aren’t any hidden environmental red flags that could impact its value down the road.
The current economic recovery cycle is affecting lender behavior in the market, too. Lenders are recognizing the signs that a recession could be on the horizon and are conducting stress tests — looking at their portfolio to highlight loans that may present the highest risk in the event that the market transitions into a downturn.
In addition, risk managers at financial institutions are making sure they maintain the same overall concentration limits for commercial real estate exposure throughout the recovery period to protect themselves and avoiding loans on higher-risk assets like outdated malls or older office buildings.
Meanwhile, a third tactic lenders are utilizing is to focus on their risk management teams and having junior staff shadow veterans in the bank’s workout group as a strategy to get them thinking about the risks that may surface in a recession.
What can commercial real estate participants do to protect themselves in this market? Worry less about accurately timing the next downturn and more about maintaining quality underwriting standards. Have a detailed cash flow analysis and test your assumptions about rent growth under different scenarios to gauge what might happen to returns if expected rent hikes don’t materialize. If you are taking on a value-add investment, make sure the numbers work even under lower assumptions of property value down the road.
Even while the market is still growing it’s wise to conduct some stress testing. Look back at your portfolio, either following an established watch list of high-risk site types or generating your own high-concern list. The danger at this late stage of the cycle is that the still-strong factors boosting today’s market (strong demand for commercial properties, low vacancy rates, plentiful investment capital, motivated buyers and sellers, interest in site redevelopment) can mask the risks, and encourage lenders and developers to overreach at exactly the wrong time. There is still money to be made in U.S. commercial real estate, but it’s important to go into a deal with eyes wide open.
Don’t lose sleep trying to forecast the timing of the next recession. Instead, focus on how your risk management strategy should be transitioning to consider the potential for weaker market conditions over the near-term.