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What is a Recession?
A recession is an economic term used to describe a significant decline in economic activity within a country or a region. It's characterized by a decrease in gross domestic product (GDP), which is the total value of goods and services produced in an economy over a specific period. During a recession, various economic indicators such as employment, consumer spending, business investments, and industrial production typically experience a downturn.
Recessions can be caused by a variety of factors, including:
- Demand Shock: A sudden decrease in consumer and business spending can lead to decreased demand for goods and services, causing businesses to cut back on production and potentially leading to layoffs.
- Supply Shock: Disruptions in supply chains, shortages of critical resources, or sudden increases in production costs can lead to reduced production and economic slowdown.
- Financial Crisis: Banking and financial system failures, stock market crashes, or a credit crunch can undermine confidence in the economy and lead to decreased investment and spending.
- Global Factors: Economic downturns in major trading partners or global economic uncertainties can negatively impact a country's exports and overall economic performance.
- Monetary Policy: Central banks may raise interest rates to control inflation, which can lead to reduced borrowing and spending by businesses and consumers.
Governments and central banks often implement various measures to counteract the negative effects of a recession, such as investing in stimulus packages, additional unemployment benefits, or monetary policy like lowering interest rates.
Recessions vary in severity and duration, and recovery from a recession can take time. Economists and policymakers analyze a range of economic indicators to determine whether an economy is in a recession and how it might be impacted by various interventions.
Economic Recession vs. Real Estate Recession
A "real estate recession" is a specific type of recession that is primarily driven by a downturn in the real estate market, which includes activities related to buying, selling, and developing properties such as homes, commercial buildings, and land. While it is a subset of a broader economic recession, a real estate recession focuses on the specific challenges and dynamics within the real estate sector.
During a real estate recession, several key factors come into play:
- Housing Market Decline: Property values and home prices may drop significantly, leading to decreased demand for homes and reduced construction activity.
- Reduced Property Sales: Fewer people are likely to buy properties due to economic uncertainty, reduced consumer confidence, and difficulties obtaining mortgages.
- Foreclosures and Distressed Sales: Homeowners facing financial difficulties may default on their mortgages, leading to foreclosures and an increase in distressed property sales.
- Slower Construction: Developers and construction companies may halt or delay new construction projects due to reduced demand and tighter credit conditions.
- Impact on Related Industries: A real estate recession can have a ripple effect on industries tied to housing, such as construction, home improvement, furniture, and mortgage lending.
- Negative Wealth Effect: As property values decrease, individuals' net worth tied to real estate can decline, leading to decreased consumer spending.
A real estate recession can be triggered by a variety of factors, including an oversupply of properties, speculative bubbles, rising interest rates, stricter lending standards, and broader economic downturns. However, it's important to note that not all economic recessions are necessarily characterized by a significant decline in the real estate market.
Governments and central banks may implement targeted policies to address a real estate recession, such as offering incentives for homebuyers, providing support for distressed homeowners, and introducing measures to stimulate construction activity.
What Should a Recession-Proof Real Estate Strategy Include?
A recession-proof real estate strategy aims to minimize the negative impact of economic downturns on your real estate investments. While it's challenging to completely shield your investments from all economic fluctuations, there are strategies that can help make your real estate portfolio more resilient during recessions.
Protecting Your Portfolio
One of the primary goals of every investor should be to protect their portfolio, especially when facing a potential economic downturn. One way to do so is by focusing on cash flow. Investors should steer any capital expenditures toward improvements that generate positive cash flow.
At the same time, investors should be careful not to overinvest in their property at the expense of maintaining a healthy reserve. All rental properties face unexpected costs from time to time, from property maintenance to repairs and potential vacancies. A cash buffer can help investors weather financial challenges without jeopardizing their investments.
Factoring Risk and Yield
When evaluating real estate investments, it’s essential to also factor in both risk and yield. A risk assessment should look at market risk, location risk, property condition, tenant risk, liquidity risk, financing risk and more. A yield assessment will consider rental income, capital appreciation, and cash flow. Investors can use yield metrics like cap rate, cash-on-cash return, and return on investment (ROI) to evaluate various opportunities.
Naturally, investments that have a higher risk profile should generate more return than those with a lower risk profile. Determining the appropriate risk and yield will depend on one’s risk tolerance and return expectations. Those who are concerned that a recession is on the horizon will want to stay away from higher-risk, opportunistic deals as these can prove to be problematic during downturns.
Increasing the liquidity of your rental portfolio involves making strategic decisions that allow you to access and deploy funds more easily when needed. While real estate is generally less liquid than some other asset classes, there are steps you can take to enhance the liquidity of your rental properties. One strategy is to refinance, which can free up cash by obtaining a new mortgage with better terms. Another strategy is to liquidate underperforming assets. Third, consider bringing in investment partners who can inject additional capital into your portfolio, thereby increasing liquidity.
Beyond that, investors can increase liquidity by enhancing their cash flow (via rent increases and property upgrades) or by lowering their expenses (by renegotiating vendor contracts, making energy upgrades, implementing a RUBS system, etc.).
What to Invest in Before a Recession
The real estate market is cyclical. Historically, each cycle tends to last about 10 years, give or take. Depending on how long its been since the last recession, there may be indicators that another recession is on the horizon. This usually occurs after periods of sustained growth and is usually evidenced by slowed economic growth and rising interest rates. While it can be intimidating to invest with a recession on the horizon, there are some opportunities to invest before a recession that can prove worthwhile.
The time before a recession is a great opportunity to focus on diversification. Spread your real estate investments across different property types and locations. Diversification can help reduce risk by ensuring that a downturn in one area doesn't severely impact your entire portfolio. For example, someone who typically invests in office or residential properties may consider adding industrial or seniors housing to their portfolios. Meanwhile, someone who has traditionally invested in the Northeast or Bay Area might want to add a few Sunbelt properties to the mix.
Do Invest In
Not all properties perform equally during a recession. To prepare for a recession, consider investing in more resilient properties. Resilient asset classes tend to include multifamily (people always need a place to live!), medical office (people always need to see their doctors), and quick-service restaurants (QSRs). Quick-service restaurants, like standalone Burger King or Panera Bread facilities, tend to perform well during recessions because people scale back on in-person dining and opt for fast casual meals on the go.
Another strategy is to invest in primary markets. According to data from the MIT Center for Real Estate Development, properties in core markets (like New York and Miami) tend to outperform secondary markets (like Philadelphia and Las Vegas) during recessions. Properties in core markets historically recover faster than those in secondary and tertiary markets, as well. This is particularly true among Class A assets, which hold their value best.
Avoid Investing In
When there’s a recession on the horizon, the worst things to invest in are usually vacation homes, hotels, and retail. This is because, during a recession, people tend to scale back their discretionary spending. People travel less, for both leisure and work. This puts downward pressure on vacation/hotel prices and rental rates. Those who try to sell these assets during a recession will often find a limited pool of buyers. The same is true for retail: people tend to spend less on consumer goods and services during recessions, which drives down the value of retail properties.
Another thing to avoid is speculative development. Ground-up, opportunistic deals are among the riskiest – regardless of where we are in the real estate cycle. During a downturn, investors may struggle to access the equity or financing they need to complete these projects. In prior recessions, we’ve seen far too many investors forced to walk away from these deals mid-way through development. Those who are forced to sell at a loss, or worse, turn the keys over to the bank, risk having their credit (and real estate reputation) tarnished for years to come.
Locationally, investors will want to avoid unstable or speculative markets, as well. Markets with a history of rapid price fluctuations and speculative behavior can be riskier during economic downturns. These markets might experience sharper declines in property values.
Best Investments During a Recession
During a recession, some real estate investment strategies tend to be more favorable due to their potential for stability and resilience in the face of economic challenges. Here are some types of real estate investments that might be considered more favorable during a recession:
Rental apartments and multifamily properties often fare well during recessions. Demand for rental housing can increase as people postpone homeownership or look for more affordable housing options. In some cases, people are forced to sell their homes and have no choice but to enter the rental market. In worst-case scenarios, some people will lose their homes to foreclosure; doing so can hurt their credit for years, which keeps them in the rental market for longer.
Specifically, focus on Class B and C properties during a recession as these tend to have the highest demand. People in Class A apartments often trade down to more affordable units during economic downturns.
Properties that cater to lower-income individuals and families tend to maintain steady demand during economic downturns, as affordable rental units remain essential. There is even a case to be made for buying rent-controlled affordable housing. These properties tend to trade at a discount, but in most markets, owners can bring the rents to market level upon tenant turnover. Many people who qualify for affordable housing during a recession eventually move out once the economy recovers, and then owners can implement a value-add strategy to raise rents in these newly vacant units prior to re-leasing them at market rate.
During a recession, many people either cannot afford or do not want to purchase a single-family home. However, they still want to live in single-family housing – especially if they have school aged children and are tied to a specific neighborhood. As housing prices come down, this is a great opportunity for investors to purchase single family homes at a discount which can then be leased to families looking to remain in their local area. Moreover, those who rent single-family homes tend to lease for longer than they would an apartment, which can provide a steady, stable income stream for years to come.
Essential Retail Properties
Properties leased to essential retail businesses like grocery stores, pharmacies, and discount retailers can perform well during recessions as consumers continue to spend on necessities. This is especially true among cost-conscious consumers who spend less at sit-down restaurants and halt spending on luxury goods.
Investing in stable markets with strong job growth, diverse economies, and a history of weathering economic downturns can offer more predictability. Core markets, as noted above, tend to perform best during economic downturns and recover faster than secondary and tertiary markets. Many investors will choose to “trade up” during a recession when they can buy well-located, Class A properties at a discount.
REITs and Real Estate Funds
Real Estate Investment Trusts (REITs) and real estate mutual funds can provide exposure to a diversified portfolio of properties without the need for direct ownership. REITs, in particular, can usually be purchased at a discount during a recession. This is a great way for investors to maintain liquidity. In the event they need to sell, they can easily unload REIT shares as easily as they would other stocks. Traditional commercial real estate is much harder to sell during a recession and is considered an illiquid asset.
If you have the expertise, resources, and risk tolerance, distressed properties acquired at a discount due to financial distress can provide opportunities for value creation. In fact, many investors, including Warren Buffett, will go on buying sprees during a recession. Recessions are a great time to pick up well-located, physically stable assets whose owners may be over-levered and forced to sell at a discount.
What to Do During Recovery
Most investors will change their investment strategy as economic conditions improve and consumer confidence increases. Those who have weathered an economic downturn will want to start deploying some of their capital reserves. An early economic recovery is a great time to start investing in value-add improvements and renovation projects. Properties that can be improved through renovations or upgrades can lead to increased rental income and appreciation. People may be more willing to pay a premium for added amenities, for example, as the economy recovers.
Similarly, we also tend see an uptick in residential home flipping as the economy recovers; developers purchase properties at a discount during a recession, make improvements while the economy is down, and then sell for a profit once the economy rebounds.
The early stages of a recovery are also a great time to invest in industrial and warehouse properties As e-commerce continues to grow, demand for warehouse and distribution facilities generally increases, making these properties more attractive to investors.
Now is also a good time to invest in more speculative growth markets. Look for regions that are experiencing strong job growth and economic expansion. Regions on the rise can yield positive returns as demand for real estate in these markets increases.
Should I Invest During a Recession?
Investing in real estate during a recession can present both opportunities and challenges. There are certainly some advantages to investing in real estate during a recession, though. For example, investors can usually purchase properties at lower prices. This gives them access to assets they might not have been able to afford during the market peak.
There is also less competition for assets during a recession. Many potential investors decide to sit on the sidelines during economic downturns. Lower competition for assets can create more favorable buying conditions for those willing to invest when there’s market volatility.
Lastly, the returns on properties purchased during a recession can also prove to be higher. This comes through higher cap rates, which we usually see as property values come down. In the short term, this can translate into higher cash flow. In the longer-term, this can translate into greater appreciation as buying activity picks up when the economy recovers.
It's important to recognize that market conditions and economic recovery patterns can vary widely based on location and other factors. Research, due diligence, and consultation with real estate professionals and financial advisors are crucial when considering any investment decisions. Additionally, consider your investment goals, risk tolerance, and investment horizon to align your choices with your overall financial strategy.
That said, those who are conscious of where we are in the real estate cycle, and invest accordingly, will generally reap the most benefit from their properties.