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Prepare and Survive a Recession as a Real Estate Investor

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Prepare and Survive a Recession as a Real Estate Investor

This is a tough but necessary subject matter in the real estate investment business. In any normal 40 year career in real estate investment and development, you can expect to experience anywhere between 3-5 recessions or market downturns. This paper is not to teach you how to anticipate or read the market cycle (although we do advise to track it below), but to educate you about how to prepare and what to do when one (eventually, and always) arrives.

For me, this is written from brutal and personal experience. I founded Urban Pacific in 2000, so we’ve been through two recessions. I can also remember my dad and Uncle Mike going through the recession in the late ‘80’s early 90’s - “Stay Alive ‘til ‘95” industry folks said then.

First was the 2001 recession, which had little or no real effect on the real estate development marketplace in Southern California where we are based as this was predominantly related to the internet bust. I do recall there were some killer low prices on office building, and everyone said Silicon Valley was dead. I told someone at the time, go buy office buildings below replacement cost, wish I’d had the capital to do so. Ends I was both right and wrong - I was generally right that Silicon Valley was not dead and buying office buildings was a correct move. I was wrong because the highest and best use of those office buildings was to tear them down and build apartments instead.

Then from 2000 to around 2006 we experienced that largest boom in residential for-sale housing development in US history. There had been larger multifamily market peak in the 60’s and 80’s. From 2003 to 2006, the market was on fire, breaking home building productions rates, prices, and absorption velocities across the US. All of course, driven by the massive volume of securitized mortgage products that we all now know as CDO’s. BTW, rent and watch The Big Short, it’s an invaluable look into the 2008 recession. First, to show you what I call “peak market thinking”. And second, to show how a very small group of smart people read the background signals and saw the downturn coming. We did not, or at least not soon enough to do anything but react.

In 2006, we were pre-selling two major high density urban for-sale condo projects in San Pedro and downtown Los Angeles. I will never forget, in October 2006, we released a phase of condos on our CityView Lofts projects in DTLA. Normally on earlier phases, we were oversubscribed - multiple offers for each unit in the phased release - where all units sold out in each release. This time however, we did not get a single bid, like zero. I asked our sales team: Maybe the email system is broken, or some other technical issue? Their response: “we thought that too, we checked, but everything is working perfectly in the system”. Oh shit...

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Beginning to prepare for a coming recession:
To begin, prepare and manage your moods about a recession. Recessions and peak markets are both fundamental parts of the marketplace, the timing is always different, and they always begin and end at some point in time. Second, be in a mood of vigilance, meaning still doing business but watchful. It’s too easy to go down the negative rabbit hole if you always dwell on the negative, that everything is terrible and will never end. It’s also easy to have a blind spot that all will be good forever, and that “it’s different this time” when folks suggest suspending belief in fundamental economic principles...markets do go up, and they go down, and they go up again, and so on. The trick is to be vigilant (my mood) and anticipate, design and prepare to act in a downturn. The most money I’ve ever personally observed people make is in a downturn. We advised major banks on distressed assets during the 2008 recession and saw huge discounts on real estate assets that were once in a lifetime opportunities:
“It‘s nuts when people are in bad moods during a downturn, and happy in up markets.” - Toby Hecht
“Be fearful when others are greedy and greedy when others are fearful.” - Warren Buffet

Useful Lessons To Use For Your Investments

Be wary of what I call “peak market thinking”. I termed the phrase “Peak Market Thinking” which is a general euphoria surrounding amazing almost magical upward market movements. When you are in it, it seems like it can be no other way, like it’s the “right and perfect” time, that it can never go down or get bad, and that any crazy assumption must be right. Most importantly, look for language like “it’s different this time” explaining away why economic principles are being suspended. Those are signals that the downturn is coming.
Ultimately, all markets rise and then fall, then rise again. The difference from cycle to cycle is the timing.

Be wary of delayed production cycles that push your project into the downturn: That include delays and other breakdowns, that may delay your completion and sale/lease up, that ultimately carry you into the downturn. Most seasoned developers, are hyper-focused on speed of execution of the build and absorption cycle, because anyone who has ever been caught in the downturn never wants to go there ever again.

Be cautious of overly abundant credit, i.e. particularly construction debt: The 2008 downturn was a bursting of the CDO/MBS credit bubble. People could buy our downtown loft condos as the prices we projected, solely because of the available debt products on the purchase mortgage side. Plus, it gave buyer’s a sense of invincibility, which we got sucked into. Finally, abundant credit drive FOMO or “Fear of Missing Out”. In this sense, it was buyers being outbid by other buyers in Peak Market Thinking, and so folks got ever more aggressive. Don’t get caught up in the thinking of the masses, either the general market, media, or other developers. Take everything with a grain of salt, investigate every declaration that somehow economic principles are not applicable “this time” Remember web companies in 2000, no need for profitability, it’s different this time. Right… One thing we track, is the availability of non-recourse construction debt, this was more than abundant in 2004-2006, like silly easy to get. Also, super aggressive mezzanine debt/equity. Beware easy credit terms and non-recourse construction debt.

Watch for signals in the background noise.
We looked at another adaptive reuse loft deal in DTLA in early 2006. We underwrote the sales prices for a loft conversion project at something like $600 per s.f., where we were preselling at $500+ psf in our existing projects. I couldn’t make the deal pencil unless I boosted the price per square foot to over $600, and I just could not get comfortable with that price, it seemed crazy at the time, and it was in hindsight. To ground my assessment about $600 plus being crazy or not, I asked the sales team to meet me at the project site, and I asked them, can you support $600 plus PSF?They came back with “Not really, not comfortably”. Ultimately, we (correctly) declined the deal. The reason to tell you this story, for most professionals, there is some sense of downturn related changes or crazy aggressive terms in the background of the marketplace, and they may not be obvious. They’ll be subtle, and drowned out by the “it’s different this time” background noise. Particularly, for developers, who are die hard optimists and focused on execution of their deals, this can be lost in the background.
Now, our team at Urban Pacific is exceptionally sensitive to the small signals, as well as, we have better cycle tracking tools that we use, and review regularly. Most importantly, we have more powerful networks of people in other markets, and other locations, that we regularly speak with to see what they see and are experiencing from their standpoint. We share our insights with them also.
Ultimately, when you haven’t been through a downturn (2008 was the worst in a generation from my conversation with long time professionals) you cannot know what a downturn really is. It is surreal, unbelievably good, while at the same time lots of people are saying “it’s different this time” and you believe you want to believe it so badly, to ignore the possibility that the market can turn down. From one of my primary learning networks - Toby Hecht at the Aji Network - says it best: “markets go up, and they go down, and they go up again, and so on”. He means there is no suspension of the reality that markets go in cycles, always, and without fail. The key is that the timing is always different from cycle to cycle, and that’s the complicated part. But if you always orient around realities operations, that if we’re up, we must eventually do down, and vice versa than at least you will be in some anticipation about that eventuality.
Given all this, I wrote this to prepare you for the eventual downturn. Know this: I am not in a bad mood about the next recession, but I am in moods of vigilance, anticipation, planning, and preparation. As developers and investors, we must take risks, or there will be no financial return. The key is to be prudent, i.e. risk enough to generate ROI, but be prepared for the downturn. As Toby so elegantly puts it: “Be in moods of wonder and ambition”
These are the key areas of consideration of your planning for the next recession. Planning is key to survival. Believe me, it’s much better to suffer somewhat now to prepare and save, then to deal with it when it arrives unprepared.

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How to prepare yourself and your investments:
Key areas of consideration is planning and preparation in your investments:
How are your investments leveraged? Are your projects and their sponsors taking on appropriate amounts of debt, both on the construction loan and permanent loan underwriting? Do your construction and permanent loans match in relative size, so that your perm loan can pay off your construction debt given rent projections?

Think about using lower loan leverage, which can take the stress of down markets and possibly lower rents.

Are the rents proposed in your investments trended? Do they assume some significant “bump” us in rents during the construction of the project - applies to either new construction and value add investments. If they do trend, how does the investment look if you take the trending out of the model? Does it survive? If not think hard about changing the deal parameters or not making the investment.

Did you keep sufficient personal savings in the bank? We see too often that investors get lulled into a sense of security in “peak market thinking” and go all in - put all their life savings into that deal that promises super high returns, again based on “peak market thinking”. Then when everything changes, they are ill prepared to deal with 2-3 years of down cycle.

Are your investments dollars in a project that can sustain a downturn? We like multi-family rental because on average in the 2008-2010 recession, rents in Southern California where we are based, were very stable. Plus, we are in a highly constrained development marketplace related to approval for new projects. Very tough place to get new projects built. Supply constraint is a protective mechanism for more stable rents.

Is there a plan for stabilizing and renting the project if it does not sell? Do you have your operating agreements contemplating a forced long term hold scenario? Too many times we saw projects forced to sell in the worst part of the downturn because their bank/investors/partners required it, or sponsor or other investors panicked and forced a sale at the worst possible time. Generally, anyone who held onto their rental properties during that time in Southern California tended to have relatively stable cash flow assuming no major oversupply issues in competing projects. Multifamily values did fluctuate, but if you were long term hold money, and did not have to sell a stable, income generating asset, then you were not forced to sell and could look forward to a property valued at or above where you started after the recession was over. Just to be clear, we are speaking about multifamily rental housing, and not condo/SFR markets.

Is the sponsor of your investment prepared themselves? Have they made a plan of action in this event? As an investor, you would always want your sponsor to do this, but it would be prudent to have that conversation early.

How to be with your developer/sponsor partners:
Tell them:

Communicate always. In many of the distressed asset deals we advised on, it was clear the sponsor was long gone, and there were signs long before that they had stopped communicating. In our own deals, we communicated often, and remained available to our investors if only to give confidence that we weren't going anywhere.

Take your lumps, communicate early and often
Protect the deal, don't give up, don’t leave town
Realize it will end

How to prepare yourself and your family
Prepare your household budget preparation - have 2-3 years of savings on hand, do the math, know your household budget and what it will take to survive.

Prepare your family - most importantly your spouse. We saw too many marriages end in the recession.

Do whatever you need to do to protect your moods - moods of enthusiasm and wonder, positivity about colonizing the future.
For yourself - realize it will end

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Track the market, use an array of strategic and effective tools
The action to always be paying close attention to the market, but not in the usual way. I don’t mean pay attention to mainstream media, media and economic pundits, or anyone person or group who has an opinion. You want to use an array of tracking tools and indicators, so that you are not focused on any one indicator.
Presently, we use two main tools to track the market and cycle.

First, is the Bar Analysis Grid, published at the website Econ P.I. www.econpi.com

Second, the blog Calculated Risk, written by Bill McBride www.calculatedrisk.com.
Amazing housing graphs and pragmatic assessments of the housing markets.

There are various other, yield curve inversions, which can be found here: https://fred.stlouisfed.org/series/T10Y3M
Robert Charles Lesser and Co. are a great resource.

We have something like 20-25 websites and quarterly reports that we track.
Listen for signals, they will be subtle, listen for “it will be different this time”

Prepare for major real estate deal opportunities in the downturn.
As I said earlier in the article, we saw some insanely discounted broken condos projects, where the banks had stopped funding halfway through construction. We expect the next recession to be different (obviously) possibly not real estate centric, and possibly not affecting highly supply constrained marketplaces as much.
We see these as possibilities:
Invest in assets that can sustain a downturn, have investment windows that go well beyond a potential downturn, and have a “stick” tenant base that’s not likely to leave town.
Distressed value add assets - given that this is a very robust market where investors and sponsors are regularly overpaying or having to go to out of state markets and tougher market to get returns that make sense, we believe there will be some deal distress in the value add space.
Distressed new construction podium deal with high percentage of studio and one bedroom units. Seeing many of these types of deal being built all over the US, these deals have high levels of competition, and therefore some markets will be oversupplied. Thus generating leasing and sale value distress that can be captured.

Closing
This article is sensitive for me to write, no one wants to expose past breakdowns and missed economic signals. But use my experience and lesson to enhance and amplify your actions now to be preapred and capture territory during a downturn. My logic is that everyone can learn from others in this particular domain, and I see lots of investors that have not been through the craziness of a downturn and need to prepare.
As always, I am an offer of help. You can find me on LinkedIn, Twitter, IG, and Facebook.

~ Scott Choppin

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