Pandemics, Supply Chains, Recessions, Multifamily and Market Selections
Unless you have been on a spiritual retreat in the desert for the last few months disconnected from any sort of technology and outside human connection you have heard about and likely already felt the impact of the novel coronavirus COVID-19. This epidemic which originated in China has rapidly spread to all corners of the earth causing the World Health Organization to declare COVID-19 a global pandemic.
As of the writing of this article the COVID-19 health crisis has left more than 3 million infected and hundreds of thousands of people dead with the numbers continuing to rise each day. To control the spread of this virus many countries have issued stay at home orders effectively bringing businesses to a grinding and unforeseen halt. The whiplash from this sudden stop in the economy has created another crisis – an economic crisis. In the US, records were broken on a daily and weekly basis for stock market crashes, unemployment claims, federal funding bills and more.
The Coronavirus, Black Swans and Real Estate
The Coronavirus is a black swan event – a term in the world of economics and finance that refers to an event that is rare and unpredictable (like seeing a black swan) which is of such a magnitude that it impacts everything in life as we know it. As an investor, whether in the stock market or in alternative investments, the question on everyone’s mind was “will this be worse than the great recession of 2008?” - an experience still fresh in everyone’s memory. While the definition of a recession is two (2) quarters of sustained economic contraction most pundits have already sounded the alarm that the US is in a recession.
While we could go into why the 2008 Great Recession and the 2020 COVID-19 induced state we find ourselves are different, I think a more valuable lesson on market contagion is presenting itself. As we watch the news each day it is like someone has pressed the fast-forward button to 20x speed on our economy and we can more clearly see the spotlight on how recessions spread. As investors our goal is to appropriately mitigate our risks to get the reward of return on our investments. Understanding the way recessions spread through an economy gives us insight in how we should invest to protect ourselves, preserve capital and ultimately grow our investments during this pandemic and similar future events.
So, what do Pandemics, Supply Chains, Recessions, Multifamily and Market Selections have to do with each other?
Impact Of Interconnected Economy
Our economy is interconnected and doesn’t act in isolation. Take for example the supply chain story of Larry La’s Chinese eatery. This restaurant owner had to shut down his restaurant due to the coronavirus which led to 36 employees losing employment. This created a chain reaction where the produce distributor that services his restaurant lost a major client and the related revenue the distributor would have earned. With a reduced number of restaurants needing delivery of goods, the producers of goods suffer as they receive less orders from their distributors. As a result, the producers of goods have no orders for their truckers to transport.
While this story stops here what would it look like if we continued? All the recently unemployed staff of the restaurant and the distributor, producer and trucking company employees earning less income (if not laid off) now have difficulty in paying their bills. They are not able to pay their rent or mortgages. If they are still able to afford these large expenses they will cut back on other discretionary spending; they may go out to eat less, decide not to go on vacation this year, pass on buying that new gadget, car, and clothing they were planning on buying before the pandemic hit.
They may even still have the same level of employment as before but choose to save more of their money given the uncertainty about their economic futures. Now the employees at the car dealership and clothing store are earning less because less people are spending and these employees will also reduce their consumption of goods, going to restaurants and other discretionary spending. This could lead to another restaurant going out of business and the downward spiral continues. What was thought to be an epidemic that would only impact the tourism and hospitality industries, COVID-19 has become a pandemic impacting all industries.
Connecting Economic Downturns To Multifamily Investments
One of the main drivers in value of multifamily real estate is the net income it produces. If residents are not able to pay their rents, then the building creates less revenue and has a decreased value. This may be good for investors waiting on the sidelines looking to pick up bargains but can mean missing return targets for those investors holding these properties. The other driver of multifamily real estate value is the cap rate which is a measure of the view of risk related to a specific market and asset type. This is heavily connected to overall confidence in the economy of the market.
How do investors mitigate this risk?
There are many things sponsors can do in their ongoing asset management to help improve their rent collections even during a pandemic, but the answer might be even more simple than this and starts long before the pandemic ever hits.
It’s about where you start. What market are you investing in?
Understanding The Importance Of Market Selection When Investing
It’s about where you start. What market are you investing in? It is widely known that diversification is a hedge against risk when investing. Jobs are one of the most important factors to look at when you are selecting a market to invest in. Jobs are how residents pay rent. Right along side with reviewing the quantity of jobs you should also review the diversity of jobs and employers.
You should aim to invest in markets where no one industry or company employees over 25% of the population. This would be an ideal market for investing. Imagine if the market you invested in was 80% tourism and hospitality? Once the pandemic hit a large majority of these individuals would be left without employment. This would reduce your potential pool of qualified renters to fill vacancies and if any of your residents worked in this industry then they would have difficulty paying rent. The combination of less applicants and less paying residents leads to a recipe for increased physical and economic vacancy on a property.
Note this benchmark may not be a deal breaker but if you invest in a market where there is a significant concentration of employment in one industry you will want to have other mitigating factors such as population growth, age, unemployment, job growth and the reasons driving that growth.
What Many Investors Miss When Reviewing Investment Opportunities
Further, your review of the job diversity should not stop with your market. When you are reviewing a potential asset for acquisition you should do an employment audit of the residents and get an understanding if there are any concentrations of certain employers or industries among the residents. Keeping track of this during acquisition and on an ongoing basis helps to identify potential risks that may result from having a concentration of one employer or industry at your property. Remember our example before of the tourism and hospitality industry? Imagine if your property was 80% occupied by individuals in tourism and hospitality. Now not only do you have difficulty getting new tenants, but you have a significant problem collecting rent at your property.
An adage my grandmother would always tell me is that “an ounce of prevention is worth a pound of cure.” In the light of this pandemic and resulting recession that wisdom is even more clear. You can manage risk once a black swan event happens, but it is even more impactful to make decisions upfront in your investment criteria that help to protect you in the event something unexpected happens.
Stay healthy, physically and financially.