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There has been increasing discussion about the potential of a real estate recession. This has lead many to consider recession-proof real estate investing strategies. Among various asset classes, multifamily real estate stands out as a particularly resilient choice during economic downturns.
In this article, we delve into the reasons multifamily real estate stands out as a recession-resilient asset class. Especially when compared to other product types. We’ll also examine how to strengthen and even grow your multifamily portfolios despite facing economic headwinds.
Exploring the Recession-Proof Nature of Multifamily Real Estate
Although not entirely immune to market downturns. The multifamily sector generally retains its value better and outperforms other property types during real estate slumps. There are several reasons for this, including:
Everyone needs somewhere to live
Regardless of what’s happening with the economy, all Americans need a roof over their heads. This is true whether we’re in a high-interest rate environment or not, whether people are facing job losses or not.
In fact, during recessions, foreclosures often lead people to move into rental housing while rebuilding credit. Similarly, apartment dwellers planning to buy homes may delay purchases, choosing to save money and rent until the economy recovers. This combination of factors creates increased and prolonged demand for multifamily housing during periods of economic stress.
Federal policies benefit the multifamily industry
Historically and notably during the pandemic, the federal government has promptly intervened with relief when the economy nears collapse. For example, during the pandemic. As millions of Americans lost jobs, the federal government issued stimulus checks to help them pay rent and stay afloat. This kept cash flow coming in for multifamily investors, which prevented the widespread loan defaults that many initially feared.
Units tend to have low turnover during recessions
Moving from one apartment to another entails costs. Signing a new lease typically requires first, last, and a security deposit, amounting to thousands of dollars. Then there are the actual moving costs, like renting a truck or hiring a moving service. In a downturn, many renters will opt to resign their existing leases as a way of deferring these costs until economic conditions improve. This helps to ensure low turnover and low vacancy rates at apartment buildings.
The big exception to this is among Class A apartment buildings. In an economic downturn, cost-conscious renters often switch from Class A to Class B+/B apartments to save money. Owners of Class A apartments might need to offer incentives, such as two months’ free rent. This helps fill vacancies and encourages current renters to stay.
Multifamily generates consistent, stable income
Owners of fully-stabilized rental properties often find that these assets tend to provide steady, consistent income even during economic downturns. People often prioritize rent over other expenses like credit cards, medical bills, and utilities due to the fear of eviction.
Owners can often increase rent even during downturns
Ironically, the demand for multifamily housing during downturns often allows landlords to increase rents, even amidst economic headwinds. This is especially beneficial to landlords operating in an inflationary environment; higher rents can offset the costs of rising expenses. Those with low-cost, fixed-rate debt may even experience greater cash flow as rents increase.
How to Acquire Multifamily Assets During a Recession
It’s true that multifamily properties tend to hold their value well during periods of economic uncertainty. Particularly when compared to other commercial real estate asset classes. However, during periods of extreme distress, such as the Dot-Com bust and during the Global Financial Crisis,. There may be great buying opportunities for discerning multifamily investors.
Here are some of the strategies for buying multifamily properties during a recession:
1. Start by conducting thorough market research. Look at the local and regional market to identify areas with strong fundamentals, like job growth/employment diversification and population stability. As these markets are the most likely to rebound first coming out of a recession.
2. Consider why a property is “distressed”. There are generally two reasons for distressed real estate. Most people focus on the first scenario, where properties have deteriorated physically and need major capital improvements beyond the owners affordability. Physically distressed assets have lower rents, higher vacancies, and correspondingly lower values.
However, the second reason pertains to a distressed capital stack. In such situations, the property is physically fine, but the over-levered owner can no longer afford their debt. This situation can arise for several reasons, like rising interest rates or an unaffordable balloon payment due on a loan. Typically, owners would just refinance but in a market like we have today, with interest rates more than double or triple what they were just a few years ago, refinancing might not be an option. These owners may be forced to sell, often at a lower price than they were anticipating. In worst-case scenarios, some owners will just turn the keys over to the bank.
Landing a "good" deal during a recession often
requires a buyer to be well capitalized.
3. Line up your financing. Landing a “good” deal during a recession often requires a buyer to be well-capitalized. Those who can purchase with cash will be the best positioned to move quickly. However, this isn’t always feasible – especially for those looking to buy multifamily assets that cost millions of dollars.
Instead, use this time to reach out to your long-term lending partners to explore what financing may be available to you given the current market conditions. In some recessions, we’ve seen the Feds lower interest rates to stimulate the economy. More recently, though, we’ve seen the exact opposite – the Federal Reserve Bank has increased the benchmark rate again and again to combat spiraling inflation. Now, interest rates are significantly higher than they were even a year ago, which is making it harder for some deals to pencil out.
This is also a good time to be creative with your financing. For instance, as financing from traditional lenders dries up, some multifamily sponsors are bringing in preferred equity (although sometimes, at a higher rate than they would like). Others are exploring seller financing in which the seller holds the note to the property, which can “rescue” the owner of a distressed property by providing an influx of cash, while benefitting the new owner who may be able to negotiate a lower interest rate using this arrangement.
4. Be patient and analyze deals carefully. During economic stress, there’s a real temptation to quickly jump on a “good” multifamily deal. Prospective buyers should be patient. Not every deal will turn out to be as lucrative as it may seem on the surface.
To that end, be sure you are really digging into the financials. Aim for properties that have strong in-place cash flow, or that could have strong cash flow after executing a thoughtful value-add strategy. Be sure, of course, that you have the cash on hand for any value-add improvements that may be necessary to stabilize the property. It may be some time before properties begin to appreciate again, so focusing on cash flow is typically a wise idea for multifamily investors.
5. Tap your existing relationships. Most owners will not be forthcoming about owning a property in distress. This is a great time to leverage your trusted relationships – with other owners, brokers, and lenders – to gain intel about potentially distressed properties in need of a partner or outright buyer. Oftentimes, your network will uncover better deals than you’d find on the open market.
What Type of Multifamily Property to Invest in During a Recession
There are different schools of thought about what type of multifamily assets to buy during a downturn.
Some investors will use a downturn to “trade up” into higher value assets in better locations. For example, they might sell a 50-unit apartment complex in the outer-urban core and trade up into a higher-valued 20-unit building in a prime downtown location. This school of thought assumes that a) as property values decline, well-located assets can be purchased at a discount during a recession and b) core markets will inevitably recover and these properties will eventually be worth significantly more.
During extreme distress, discerning multifamily
investors can find great buying opportunities.
Other investors, though, will instead focus on growing their portfolio of Class B and Class C apartment buildings. The thought here is that, during a recession, these properties remain in the highest demand. You have cost-conscious renters flocking from Class A properties to these. You also have prospective or former homeowners who are forced into renting and in turn, rent more affordable Class B and C units.
Either of these strategies can be effective.
There is some evidence, according to the MIT Center for Real Estate, that during a recession, multifamily property in primary markets tends to hold its value better than real estate in secondary markets. Primary markets also recover faster than secondary markets (though, this study was conducted pre-Covid and some would argue that there’s new evidence indicating otherwise—e.g., downtown San Francisco and Manhattan real estate continue to struggle).
Then there are product type considerations.
Two product types that continue to perform well, even during recessions, are student housing and seniors housing. Each of these product types were uniquely affected by the Covid pandemic in which universities had to temporarily shut down and assisted living facilities became ground-zero for infections. However, in most scenarios where a recession is not caused by a global pandemic, these product types tend to outperform other multifamily asset classes.
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This is because during a recession, more people opt to invest in their education and therefore, demand for student housing increases (both on- and off-campus housing). Moreover, people continue to age regardless of market conditions and therefore, continue to rely on the services provided by senior housing and assisted living communities.
How to Add Value to Existing Multifamily Assets During a Recession
Rather than growing their portfolios, many multifamily investors will shift their focus to strengthening their existing portfolios during a recession. Here are some of the various strategies investors employ to add value to their existing properties:
Carefully consider tenant retention strategies
Typically, most owners will focus on keeping existing tenants in place. They might offer to keep rents steady or provide other little sweeteners to mitigate against vacancy. However, in some cases, this is short-sighted. Instead, owners should take a careful look at their units in the context of existing market conditions. If tenants are not currently paying market rent, it may be more lucrative to increase rents – even dramatically – even at the risk of the current tenants leaving.
This is especially true in markets with rent control. While rent control policies vary from place to place, most cap rents at a certain percentage per year. However, these regulations generally allow owners to bring those units up to market rate after a tenant vacates the property. For example, if a long-term tenant has been paying $1,600/month for several years and market rent is now closer to $2,100, it may be more advantageous to have that tenant leave. The unit may have some downtime while it is re-leased at market rent, but the increase in rent will probably offset that cost in short order.
Renovate units as they turn over
It can be difficult to renovate and upgrade units while there are tenants in place. Instead, as owners become aware that tenants will be vacating (e.g., they decide not to re-sign a lease), they can begin to prepare to overhaul those units before re-leasing. Sophisticated owners will have all of their materials, supplies, and contractors in place to move quickly upon the units becoming vacant so they can make the units rent-ready as quickly as possible – thereby reducing downtime and the cost of vacancy.
Invest in strategic property improvements
For many years, the multifamily market was so strong with such low cap rates that owners could put off major capital improvements. Some owners operated their apartments like ATMs – long-term, low-cost debt and double-digit rent increases have made multifamily properties especially lucrative. However, owners who are sitting on significant reserves may want to tap into that money to make strategic property improvements. This could be adding or upgrading building amenities, enhancing building lobbies and other common areas, and/or investing in energy upgrades that result in long-term savings.
Recondition vendor contracts
Recessions are a great time to reevaluate all of your vendor contracts. Look at what you’re paying your property manager, leasing brokers, landscaping crews, repair and maintenance providers, etc. This could also include your attorney and your asset manager. Reconditioning their contracts and locking in long-term, reduced rates can help increase cash flow during recessions.
Identify operational savings
There are two ways to increase cash flow: 1) increase income and 2) reduce costs. Multifamily owners will want to look explore various cost-cutting measures such as implementing a RUBS system that bills tenants for their pro rata share of the utilities. Another strategy is to really evaluate your property management, whether this is handled in-house or via a third party. Consider your management team’s performance against common industry KPIs, such as rents, vacancy rates, repair and maintenance costs, the average cost to re-lease a unit, how long it takes to make a unit “rent ready”, and more.
Explore permits or zoning changes that enhance the property’s value
“Entitling” a property is another strategy that savvy owners will utilize to add value during a downturn. Let’s say an owner has a 20-unit apartment building that sits on four acres of land. The owner may use this time to subdivide the lot and then pursue the permits needed to build another apartment building on the newly created lot.
Even if the owner does not ultimately build that second building, the simple fact that they have the permits in hand to do so automatically increases the value of that property. As market conditions change, the owner could sell that entitled lot to someone looking to construct a new building for that use. Pre-entitled land is considered valuable to buyers as it takes the permitting risk out of the equation, as permitting can be a long, expensive and uncertain process in many communities.
Federal policies benefit the multifamily industry
When the economy is on the brink of collapse,
the federal government quickly steps in to provide relief.
While the prospect of a recession can be scary, investors need to remember that the real estate market always ebbs and flows. Most cycles last around 10 years, give or take. We’re about 14-15 years out from the last true recession (the Global Financial Crisis) which means the U.S. is due for another. Anyone who’s in the business long enough will experience multiple downturns. How people act during these periods will influence how likely they are to recover.
With a recession on the horizon, investors should be taking proactive measures to insulate – or even grow! – their portfolios to ensure they’re able to weather this next storm, regardless of how severe it may be.
