Winter is Coming to Commercial Real Estate

A commercial real estate developer shares his insights on how to prepare for it.

By John E. McNellis, Principal at McNellis Partners, for The Registry:

On Friday, the S&P 500 was down 2.8% for the year. Like a dead rat in the basement, everyone can smell the next recession, everyone knows it’s coming, but no one knows when. Nobody. The clever pundits give its commencement the same wide berth they would accord that moldering rat.

One acquaintance, however, rushed in where economists fear to tread and called it, proclaiming March 2020 as the next recession’s kick-off. He could be right. Having predicted five of the last three recessions, I have no idea but, at the risk of putting mittens on at the outset of Indian summer, it may be useful to consider how a real estate professional might survive a financial winter.

Suggestion #1: Keep your job.

As truisms go, “now is always the right time to get into real estate” isn’t bad, it has a nice ring to it, it even makes some sense, but there are better and worse times to ditch your day job for the joys of working without a net. Today is one of those worse times.

With the economy having baked longer than one of my mother’s unfortunate Christmas turkeys, the percentage play would be to keep your paycheck over the next several years. The time to BASE jump is at the depth of the recession—when you’re closer to the ground—not the week before it starts.

Suggestion #2: Sell.

Whether you own a single duplex or a portfolio you take your shoes off to count, ask yourself a simple question: Should I sell before the snow flies? Benjamin Franklin observed, “There are three faithful friends—an old wife, an old dog and ready money.”

It takes decades to earn an old wife, but you can achieve ready money with one quick sale.

What should you sell? Your sitting ducks: your projects leased at top-of-market rents, those rented to marginal tenants and those most susceptible to future competition (i.e. located where land is cheap and zoning codes are broken as often as the 10 Commandments). And your over-leveraged properties. What happens to your project if commercial values plunge 20%  or more (they tanked 40% in the Great Recession) and you need to refinance in the next five years? Would you have any equity left? Would you be able to refinance at all?

To this point, we have sold five small, single-tenant properties thus far this year, are in escrow to sell two more and are dickering with a potential buyer on an eighth. We had no need to sell any of these properties; rather, we thought it was a good time to harvest profits and deploy the cash elsewhere. Against this wave of selling, we traded several of these properties into one much larger asset, a well-located, supermarket-anchored shopping center.

Suggestion #3: Pay down debt and finance long.

How did we use the cash that didn’t go into the trade? Simple. We paid down debt and, in one case, bought out an equity partner. Our company goal has always been to carry as little debt as possible at a fixed interest rate with the longest term we can obtain.

Yes, this strategy is too conservative in good times and acts like a drag chute on new deals. And, yes, you can feel dumb when everyone else is doing five deals to your one, but you will feel much smarter, if not to say downright smug, when the recession deep-freezes the markets and your bankers will still buy you lunch.

These suggestions are easy enough to swallow: Staying put is a piece of cake, selling can be fun, and repaying debt is kind of like going to Sunday mass: It can be a little painful, but you feel better afterwards. Harder to accept is this:

Suggestion #4: Drop marginal projects.

If you’re not already under construction, reevaluate your project and ask yourself whether it still makes sense. If your numbers now look skinny, sell it or mothball it. Newton’s first law of motion (objects in motion tend to stay in motion) has claimed many victims; you have no wish to be one. Also known as inertia, this law is a major factor in the high rate of divorce—the bride figured out her fiancé was a bum long before the rehearsal dinner, but her family had already sent out the invitations and rented the hall.

Inertia also drives a world of bad deals. You’re half way through your permitting process when you notice the first frost on your pro forma—leasing has slowed, lenders are edgy and contractors insouciant—but you push on with lower pre-leasing and perhaps a second-tier, more expensive lender. And then, if you somehow missed the news beforehand, you discover just how much construction costs have soared in the last couple years. Yet you persist, marching down the aisle, telling yourself the project’s financials will look better on completion. They won’t.

One major apartment builder in Northern California told me yesterday that construction costs here are rising 1% a month (yes, 12% a year) and that if you factor in the rental concessions his company is now giving away, they are not meeting their targeted returns on investment. He also said that some smaller developers are already giving up the ghost on their new apartment projects, irretrievably buried beneath the preferred returns due their financial partners, unable ever to make a personal profit on their developments.

The strategies that work so well in a bull market can take you down in a recession. When it freezes, animals adapt. Bears hibernate, birds fly south and bees live off their summer honey. Time to start thinking about adapting. By John E. McNellis, author of Making It in Real Estate: Starting Out as a Developer.This article was first published on The Registry.

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