Investing in Commercial Real Estate During Recessions

I recently received a question from a friend: “What type of commercial property is least risky during a recession?” Another way to pose this question is as follows: “What is the most stable commercial real estate investment during recessions?”

If you are planning to invest in commercial real estate as we approach a potential recession, here are a few factors you should consider:

Let’s examine the pros and cons of each major type of commercial real estate property: Multifamily, Retail, Office, and Industrial.

MULTIFAMILY:

PROS:

  • People will always need a place to live, so it’s usually considerably easier to find tenants / fill vacancies quickly. The less time a property sits vacant, the more stable the property.
  • Apartments have many units, so if you DO have a vacancy or two, your occupancy will never drop to ZERO like it could with a single tenant building in another sub-sector. For example, 1 vacancy in a 20 unit building still allows you to retain 95% of the property’s gross income.

CONS / RISKS

  • Landlord & tenant laws can be a major challenge depending on your market. This is very state/county specific, so it’s worth taking the time to study. In Los Angeles, we have very tenant-friendly laws, which creates challenges for landlords that result in a direct loss of income.
  • Rent control ordinances are another challenge for multifamily investors. Rent control laws dictate how much you’re legally allowed to charge for rent, and how much you are allowed to increase rent per year. Violations of these laws can result in paying a hefty sum in tenant relocation costs.
  • Multifamily properties can be more management-intensive than other types of commercial real estate investments.

RETAIL

Retail is a very broad category, including everything from shopping malls to gas stations to laundromats to barbershops to grocery stores to auto repair. Therefore we cannot really generalize and say it’s good or bad during recessions. The stability of a retail property, like all income properties, is heavily dependent on its location and quality of its tenants/leases.

PROS

  • Many retail tenants are consumer staples, so these are likely to remain extremely stable even during a downturn.
  • Landlord & tenant laws are less of a concern in retail. It’s pretty straight-forward to evict or seek judgement on the terms of your lease agreement with the tenant.
  • Rent control is not a concern. The rent increases are completely determined by the verbiage in the lease agreements.

CONS / RISKS

  • The ecommerce revolution has created some concern around the future of retail, and admittedly it has changed the landscape. However, there will ALWAYS be goods/services that must be transacted in-person in retail environments.
  • Senate Bill 939 was introduced earlier this year but was contested and eventually shelved. It allowed certain types of retail tenants to renegotiate and even break their leases without paying the agreed-upon concessions to landlords. Although this bill was shelved, it’s possible that similar language will appear in future bills.
  • Can sit vacant for long periods of time.

OFFICE

PROS

  • Office buildings can be stable investment if you have a solid, long-term tenant. If the property is well-located in an urban city, with a solid tenant base it is likely to remain fairly stable.
  • Office properties are typically less management intensive.

CONS / RISKS

  • However, there may be some tenant improvements up front (modifying the space to suit their needs) like with retail.
  • One of the risks may be businesses restructuring and renegotiating leases due to the pandemic. Companies have employees working from home, and the remote work trend may continue since it keeps the business overhead low. It remains to be seen how office building leases will do moving forward. It’s always case-by-case.
  • Can sit vacant for long periods of time.

INDUSTRIAL

Industrial properties include warehouses, shipping and fulfillment centers, and spaces used for manufacturing and assembly.

PROS

  • The industrial sector it has seen a POSITIVE impact from Ecommerce, since there has been increased manufacturing, storage and fulfillment of consumer goods, which all take place in industrial spaces.
  • Less build-out for tenants. Typically, tenants simply require an empty shell space as long as it meets their space, ingress/egress, and power requirements.
  • Long term leases. Less management intensive.

CONS / RISKS

  • With industrial real estate, there are typically only 1 or 2 tenants occupying the entire space. That means a vacancy would severely (or completely) reduce the income generated by the property.
  • Can sit vacant for long periods of time.

OTHER CONSIDERATIONS

The strength of the tenants is an important consideration in any market, but particularly important in down cycles. It’s critical to do your due dilligence and check the leases for the following factors:

  • The remaining term of the lease
  • Extension options
  • Annual increases to the rent (most commonly a percentage per year)
  • Tenant credit/history
  • Market rents for similar spaces in the area
  • Type of business the tenant operates – Is it a stable industry?

Retail leases are most commonly NNN leases (“triple net” leases) meaning the tenants pay their “pro rata” share of the landlord’s property taxes, insurance costs, and most maintenance costs. Check out this video about commercial real estate leases for a basic overview on all major commercial real estate lease types.

FINAL THOUGHTS

Depending on your specific goals, investing in real estate during recessions may require a more conservative approach. Do your homework about your target submarket and how it fared during previous recessions. Analyze and underwrite your prospective investments conservatively, and give careful consideration to how much leverage you take on. If you are expecting a recession coming in the near future, it may be best to hoard cash and wait a little longer for a potential dip in property values.

Recessions are an inevitable part of market cycles and no cause for panic. Real estate is one of the most powerful ways to endure market volatility and combat inflation (which is likely to follow a recession). Your best chance of weathering the swings of the market will always be to maintain strong fundamentals and be prudent in your investment strategy.

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