How can you protect a multifamily investment in a downturn?

The economy is on almost everyone’s mind these days. Before investing in real estate, it’s good to have an idea of how both your local real estate market and the overall economy are performing. Even better, you can protect your future investments by thinking about which asset classes and strategies to invest in to avoid losing money in times of market instability.

Multifamily real estate has been a resilient asset class through the last few downturns. Here are some strategies you can use or make sure that your syndication sponsors use to help your investment stay profitable through the next downturn.

Conservative underwriting

Conservative underwriting is important at any time in a market cycle, and it becomes critically important when going into a downturn. When underwriting conservatively, we keep rent growth assumptions realistic or even assume no rent growth for a year or two. We assume market conditions will be less favorable, so it will be harder to refinance or even sell as lenders tighten their lending criteria. This assumption leads to a lower expected resale value. If your deal still works with conservative underwriting, then it’s more likely it will survive a potential downturn.

On the other hand, if you see a deal that requires 7% rental growth every year and a strict renovation schedule just to make ends meet, it’s not going to do well when the market turns.

Long-term debt

When anticipating a downturn, long-term debt, such as a loan with a 7-10 year term, can be more beneficial to a deal than short-term debt.

Most recessions are only a couple of years long. If the debt doesn’t come due in that time period, there’s less risk of not being able to refinance or to sell the property for a good profit. On the other hand, if the loan term ends in the middle of a recession, you could be stuck selling your property at a loss in order to pay off the remaining loan balance.

Lower LTV

Along with a longer loan term, you can decrease your risk of losing a property by using a lower LTV (loan-to-value) loan; basically putting more of your money down and borrowing less from the bank. This will tend to lower your overall returns because you’re using less leverage, but the decrease in risk can help during a downturn. During a downturn, lenders may even lower their maximum LTV ratio to lower their risk.

A smaller loan amount will work in your favor if you have to refinance or sell in an underperforming market because you can refinance or sell at a lower price than in a strong market and still pay off your loan balance.

Increased liquidity/capital reserves

To protect a property and investors against a drop in rental income, a good strategy is to increase capital reserves so that there’s cash on hand to help pay expenses and any debt.

While raising extra capital reserves lowers the overall return, it works as a buffer against unexpected dips in income and decreases the risk of a capital call or the need to sell prematurely. If the additional capital isn’t needed and the property’s cash flows can build a healthy reserve, the additional capital can always be returned to investors.

Investing in growing, larger markets

Even during a recession, as some markets shrink, some will continue to grow, seeing population, job, and rent growth. Even if they grow less quickly during a downturn, they can still carry potential while other markets suffer losses. For example, during the pandemic in 2020, sunbelt cities like Phoenix, Dallas, and Austin continued to grow while primary cities like San Francisco and New York City suffered significant economic impacts.

So another way to protect an investment is to focus on larger, growing markets. Larger markets also typically rebound faster than smaller markets. This puts importance on doing good market research before finding an investment. Markets that are flat or shrinking now will most likely get worse during a downturn. Markets with fewer than 100,000 people have less economic potential to grow, even in good times.

Stable income

The strategies I’ve covered are great ways to hedge an investment against a downturn. However, they all still rely on an investment’s ability to produce income. That is why it is critical to choose an asset class, like multifamily real estate, that produces stable income. Multifamily properties, when managed properly, will continue to generate passive income through a recession. So long as a property has enough income to pay off its debt and expenses, the value of the real estate doesn’t matter during a downturn. If the value drops, you can continue to hold and operate the property until market conditions improve.

To ensure that you’re investing in a property that will be protected from a downturn, make sure that the projected returns have healthy cash flows, even if rental growth is flat, as opposed to banking on lots of appreciation. That cash flow over time is much more predictable than making a profit based on future market conditions.

Protecting your Investment

As a passive investor, you probably won’t be making many of the decisions about how a property is managed during or in anticipation of a less-than-ideal economy. To protect your capital investment, make sure to ask a sponsor to explain their approach and strategy towards protecting a deal during an economic downturn.