Best 5 Ways Multifamily Real Estate Sponsors Can Strengthen Portfolio Resilience as the Recession Intensifies.
by Max Sharkansky
Managing Partner at Trion Properties
The US economy will enter another recession—it’s a matter of when not if. As the Federal Reserve scrambles to curb inflation, recessionary drumbeats have recently grown louder with more observers warning the risks of an economic contraction in the next 12 to 24 months have picked up sharply.
How can multifamily sponsors prepare for the eventual arrival of a recession? Here we review several strategies to bolster the recession-resistant characteristics of a multifamily portfolio. These strategies are certainly top of mind for our team at Trion Properties—and should be for any multifamily sponsor who wants to successfully deliver downside protection while still capturing upside potential amid difficult market conditions.
Exercise discipline with debt and risky deals
As the real estate market cycle peaks ahead of a recession, many banks loosen their lending requirements and extend credit to borrowers at exceptionally low rates with high loan-to-value ratios. In a bull market, banks often allow loan-to-value ratios to creep upwards of 90%, a far cry from the conservative 65% to 70% targets typically seen during a bear market.
As a result, some sponsors become over-levered on high-risk deals in their search for higher yields during a market peak. This phase is also when we start to see novice multifamily investors—especially first-time developers—take on projects that are beyond their capacity. When a recession hits, it’s these investors who tend to lose the most.
Savvy sponsors, on the other hand, keep a sharp eye on risk and yield when investing in advance of a recession. The goal is to stay disciplined: Keep debt loads low and resist the temptation to invest in higher-risk, speculative deals. It is often worth paying a premium, even at the peak of a real estate cycle, for a property that has lower rates of return but is an otherwise less risky investment.
At Trion, one way we avoid taking outsized risks late in the cycle is by sticking to what we know best. For example, we do not buy properties where renovations would require opening up the walls. We’ve learned from experience that re-wiring and re-plumbing projects are extremely onerous and difficult to execute well. Ultimately, the juice just isn’t worth the squeeze. We love doing heavy value-add work—but we stay disciplined by focusing on properties that need cosmetic repairs to remedy deferred maintenance issues in areas such as roofing, HVAC, and siding.
In terms of leverage, sponsors can seek to reduce their debt loads ahead of a recession by refinancing into lower interest rates, if possible, and paying down any oversized loan balances. A lighter debt load improves cash flow and creates an equity cushion to help withstand declining valuations.
Take a conservative approach to underwriting assumptions
To succeed during a recession, a sponsor’s business plan must be based on assumptions that are achievable even in a downturn. This demands a prudent, thorough approach to the underwriting process.
Our team takes great care to make conservative projections. For example, our financial models are built using untrended rental growth rates, and we focus on untrended yield on cost. Untrended rents are projected rents that do not reflect market-driven increases. While it's true that rents are growing in most markets, using untrended rents in our projections is a conservative way to calculate the future financial position of a multifamily asset. By underwriting at today’s rental rates—instead of using aggressive growth projections—we create a layer of protection and strengthen our ability to perform in a variety of economic environments.
Maximize cash flow
Strong cash flow can provide powerful ballast during a recession, when property values can decline in the short term. Sponsors should ensure rents are bumped up to prevailing market rates (if not already) and implement other low-cost ways to boost revenue, for example, separately metering utilities or installing coin-operated laundry machines.
Unload underperforming assets
Sponsors can consider selling underperforming assets to increase liquidity. Having more cash on hand makes it easier to invest during a recession, which can be a great time to scoop up multifamily properties.
Many investors who are over-levered and in over their heads will be forced to sell their well-located properties at a discount during a recession, creating an opening for investors who otherwise wouldn’t have been able to afford these properties.
Stay focused on efficient, effective property management
Well-managed multifamily properties are better positioned to preserve their value in a downturn than poorly run assets. Sponsors can focus on minimizing unit downtime and building a strong, stable tenant base—and keeping those tenants happy by delivering responsive, relationship-driven service.
It’s important to note that the underlying fundamentals of the multifamily market are still quite strong and multifamily real estate can deliver consistent performance even in volatile times. Rising interest rates and increasing costs are certainly making the landscape more challenging, warranting an extra dose of diligence and discipline—but we are not worried by the current situation. By identifying the right assets in the right locations, using leverage responsibly, and adhering to a prudent investment approach, we are well-positioned to ride out the ups and downs of the real estate cycle. We are confident our track record of success in a variety of environments will serve our investors well.