Effective recessionary buying strategies used by Sam Zell and other successful real estate professionals to realize substantial profits

With the looming possibility of recession on the horizon, it’s important to get a better understanding how this might affect the commercial real estate sector so that one can recognize and capitalize on what opportunities may present themselves. Since commercial investments have less to do with the volatile intangible parts of the market, like the stock market, they often show more resilience than other assets. There is opportunity from every adversity, and realizing the investment potential during recessionary periods is how Sam Zell, founder of Equity Group Investments, came to be known as the ‘Grave Dancer’.

 

Real estate development in the US has always been correlated to the accessibility of capital rather than demand. As a consequence of banks becoming more tentative and lending slowing down during recessionary periods, development begins to dissipate which leads to the absorption of existing property. When these conditions are coupled with, shrinking demand and high inflation as we are experiencing, we see the opposite effect. Real estate prices have been surging for quite some time, but the absolute purchasing power of consumers is shrinking, interest rates are hiking, and disposable income is becoming increasingly scarce. Price correction is inevitable in the nearby future. All of the key ingredients for a recession and for educated real estate investors to begin 'grave dancing'.

 

During a healthy economy, many investors buy commercial property at a low cap rate with the intention of immediate cash flow. However, recessionary investors target distressed assets and are motivated by the notion that equity value of commercial assets acquired cheaper than the cost-to-construct will eventually appreciate to a level which justifies its original indebtedness. Though this is considered a riskier form of investing, careful analysis of each individual prospective asset furthers ensures the investor can successfully generate cashflow by achieving and maintaining high occupancy. The ability to do so in a market that is oversaturated with vacancies has much to do with superior management, marketing, competitive rates, and physical attributes of the property. The investor should be confident in their ability to withstand the carry-cost of an asset for enough time to realize equity value appreciation. 

 

To achieve high occupancy, rental rates should be highly sensitive to the current market and should temporarily be considered independently of the original project cost or debt. The marketing strategy should reflect rents slightly below the emerging market rate to fill vacancies quickly. During the turnaround period, ownership should devise a competent management system to maintain the building and ensure the timely receipt of rental payments. Latent physical defects which affect tenants further contribute to the stigma of a distressed asset which is critical to overcome. Ownership should also make careful projections of reasonable gains which account for occupancy rates, operating costs, marketing, personnel, lead generation of potential tenants, and turnover. 

 

The most challenging and detailed consideration in these acquisitions is attaining a financing structure tailored to each asset. The investor should avoid guillotine clauses, major interest accruals, and substantial personal liability. 

 

Depending on the investor’s motivation, long term appreciation in the value of brick and mortar is often more incentivizing than immediate cash flow. The tradeoff is that, often times, the desired return is not realized until the loan-to-value ratio decreases overtime as the property generates higher lease rates. Generally, the intrinsic value of real estate will always substantially increase over time given that it is well maintained and located in a stable and strong growth area.

 

During the 2008 market crash, interest rates were low so banks could carry the cost of distressed assets until recovery. An emerging solution was to ‘extend and pretend’ commercial loans to mature at a later date. Each recession is unique in the elements that ultimately comprise the economic climate and facilitated the crash in the first place. No two graves are equal, and the dance required must be tailored to the terrain. The most successful real estate investors over time learned how to anticipate corrections in the market and remain ahead of the curve. 

 

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