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Posted Jan 14, 2023

How the CRE industry is preparing for a potential downturn and eventual recovery

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Growing inflation, interest rate hikes, and higher financing costs have stifled capital market activity. Data from MSCI Real Assets showed a marked slowdown in Q3 2022 deal activity, dropping from a Q3 2021 high of $218 billion to $172 billion. And with PitchBook predicting that a recession in late 2023 or early 2024 is more likely than not, GPs are preparing to enter – and hopefully ride out – an economic trough.

And while “next year won’t be pleasant,” according to CBRE's 2023 United States Real Estate Outlook, the firm predicts that things shouldn’t get as bad as The Great Recession and recovery is likely to come sooner rather than later.

Even amidst the unknowns of 2023, one thing we know for sure is that recession is eventually followed by recovery–it’s just a matter of time. Now is the time to prepare for a potential downturn and the eventual upside.

Riding out the trough

As McKinsey reported, “It’s likely that the private sector is entering a new era of ‘higher for longer’ interest rates and cost of capital…Companies need to draw on the proven playbook for success in a world of slower growth, higher inflation, and more expensive capital…companies should also be thinking about more structural solutions that not only manage costs but also build resilience and can drive long-term value creation.”

The rising cost of capital has pushed many firms out of the growth mindset of the last decade and has put a renewed focus on taking care of their existing portfolios. With fewer new deals and fewer sales, driving operational efficiency with automation is one way to do just that.

Salesforce research indicates that process automation can reduce operating costs by as much as 30%. For CRE GPs, the ability to automate recurring (and complicated) reporting activities such as capital calls, K-1 distributions, and other statements frees up valuable time and resources. Automating the production of these reports can also help reduce the risk of human error by eliminating data silos and minimizing the intersections that investor data must cross through.

Process and data automation also helps build a more robust platform for internal teams and LPs, streamlining investor services and accounting operations. With a digitized system, LPs can easily manage their account information, payment details, and subscription documents. Ideally, systems should also ensure that these investor updates are automatically reflected in the GP’s interface. Meanwhile, fund accountants can maintain a single source of truth for the investor ledger, fund performance metrics, and the investor portal to ensure accurate and timely reporting.

In addition to automating internal processes, finding new partners to manage internal operations can create opportunities for GPs to protect their balance sheets. Since many LPs require their partners to work with a third-party administrator, GPs can directly impact their corporate operating expenses, and thus their bottom line, by working with an administration partner. Working with a third-party fund administrator also allows GPs to scale up or down as the market conditions dictate without recruiting, training and retaining employees, helping manage overhead. Outsourcing fund administration frees existing teams to focus on more high-value touch points with investors and prepare for the next fundraise, acquisition, or disposition.

Preparing for the eventual upside

A study from HodesWeill & Associates and Cornell University’s Baker Program in Real Estate found that many institutions are now overallocated to CRE thanks to the denominator effect, which helped contribute to 2022’s slowdown in investment pacing. However, reports that, unlike past downturns, institutional investors recognize that CRE fundamentals are still relatively strong. Many expect that there will be buying opportunities created by distress or dislocation in the markets.

The housing market, for instance, took heavy hits in both 2001 and 2008. However, Forbes reported that even those who bought in at the peaks still made a profit after ten years. “The average buyer at the start of the 2001 recession gained 48.59% over the next five years and 27.18% over ten…Buyers who got in just before the housing market collapse of 2008 were down -15.96% after five years but after ten were back in the green and up 7.73%. Lucky buyers who bought in prior to the 2020 coronavirus snap recession have been rewarded with gains of over 25%.”

GPs can use this period to prepare for what may ultimately become one of the best buying opportunities of their lifetime. Even if LPs take a “wait and see” approach for the next few months, there’s still interest in strategies that can take advantage of this repricing.

Communicating with existing investors will be critical during this time, discussing what they are seeing in the market and updating them on how their investments have been performing, as well as sharing new opportunities as they make sense. Since LPs value transparency but are constrained for time, having an “always on” portal where they can self-serve is essential for GPs to share critical information with investors. A modern fund administration platform can help GPs navigate data ubiquity by structuring, securing, and aggregating data into a single source of truth. This gives LPs the transparency and peace of mind they want and need.

Playing both defense and offense

As Bain & Capital wrote in The New Recession Playbook, the best businesses “...surgically restructure costs before the downturn, trimming the fat and preserving the muscle. They put their financial house in order, diligently managing liquidity and the balance sheet. They play offense by selectively reinvesting for competitive outperformance.”

Regardless of what 2023 brings, GPs sitting on a cache of deployable capital with strong investor relationships will be well-positioned to take advantage of future opportunities and reap the benefits of an eventual recovery.