"Recession and How It Affects Real Estate Professionals"
Recessions are a fact of life. Along with periods of growth, the cycles of economics include periods of decline, which generally cause the most concern for investors, but luckily there are strategies available to limit portfolio losses and even log some gains during a recession.
What is a Recession?
A recession is an extended period of significant decline in economic activity. In general, economists refer to two consecutive quarters of negative gross domestic product (GDP) growth as a recession, but other definitions exist.
Recessions are characterized by faltering confidence on the part of consumers and businesses, weakening employment, falling real incomes, and weakening sales and production—not exactly the environment that would lead to higher stock prices or a sunny outlook on stocks.
As they relate to the market, recessions tend to lead to heightened risk aversion on the part of investors and a subsequent flight to safety. On the bright side, however, recessions predictably give way to recoveries sooner or later.
The Great Recession
The Great Recession of 2008 left its mark on many aspects of our society, from real estate investment to job numbers. Though it’s been almost a decade, we’re still struggling with its legacy, from sluggish economic growth to an employment rate that is finally beginning to match pre-recession levels.
It’s hard to understate the lasting, profound impacts of the Great Recession. Yet as painful as this time was for so many, I did learn some critical lessons, particularly where it concerned investing.
Buying Homes in the Midst of a Housing Recession
When prices fall, the question is not really how low can they go? The question is how much real estate can you buy before prices go back up. If you are buying a home during a housing recession, getting a good price is just as important as being able to hold and ride out the housing recession.
Here are strategies that can help you make a wise decision and capitalize on falling prices:
Buying in a Down Market Figure out if it makes financial sense for you to buy when prices are falling. If prices haven't hit bottom yet, here's how to tell where the bottom is likely to rest, and why it might not really matter.
Looking at Overpriced Homes In depressed markets, it's not unusual for some sellers to price their home too high. If you spot a home that's been languishing on the market, it might warrant a second look. Here's how to tell.
Buying Distressed Sales in a Housing Recession Foreclosures, short sales, and REOs have differences. Read more about buying distressed properties under market value and which is more profitable for a buyer—short sales, foreclosures, or real-estate-owned (REOs). Here's how CA law affects foreclosure sales.
Before Buying a Short Sale Before you buy a short sale, read about your rights—for instance, why the seller's lender needs to approve a short sale and how to understand what is involved in closing short sale transactions.
Buying Post Foreclosures: REOS Here's how to buy a foreclosures/REOs from the bank, negotiating offers for bank-owned homes, and the difference between REO homes and short sales. You can also hire an agent to buy REOs.
Drawbacks to Buying in a Housing Recession
Not every home you spot for sale will be a good buy. Some might require extensive repairs or be located in the wrong neighborhood. The key to buying a home is and always will be location, location, location—followed by conditions.
Here are precautionary tips for home buyers in a housing recession:
How Defaults Hit Market Value Mortgage defaults affect home values. Nearby homes often feel the effect of foreclosures, especially if many foreclosures have been filed. Here's how to help an appraiser use the right comparable sales when selling a home in a neighborhood faced with recent foreclosures.
Drawbacks to Buying Foreclosures Read more here about the condition of homes purchased at auctions or trustee sales, as well as what a buyer can expect and prepare for when buying a home without an inspection.
Stripping Foreclosure Homes Fixtures are real estate because they are not personal property; they are affixed to the land, to the house, which means fixtures stay with the house. That doesn't stop some desperate homeowners from smashing walls to rip out Romex wiring or copper pipes and selling them for scrap in back alleys.
Ways to Lose Your Home Whenever a housing recession hits, the crooks crawl out of the woodwork. Here's how not to fall for gimmicky schemes, as well as top home buying and home financing mistakes and how you can avoid making them.
Buying Fixer-Uppers Some of the lowest-priced homes will be those that require extensive repairs. Here is how to buy a home that needs fixing up, and how to tell the difference between a major rehab or a home that requires small cosmetic fixes.
Here’s how to make sure your investment is recession proof:
Don’t bank on appreciation, focus on cash flow
When looking at the potential returns, pay close attention to the appreciation factor, which has a significant impact on your investment. The problem is that appreciation is an educated guess — you can’t know for sure how much your property will appreciate in the future, and when the economy shifts — it’ll be harder to sell at a profit; there will be fewer buyers in the market, because many lost money and lenders are striker with loans. That’s exactly what happened in 2008. So an investment that looks promising with a high appreciation factor might turn to be a losing deal if you need to sell it in a bad economy.
However, a conservative approach can show you if your investment is solid. When factoring appreciation, for an exit cap (the cap rate your property will be sold to a new buyer), I use cap rate that is 0.5% to 1% HIGHER than the cap rate I purchased the property with. A higher cap rate means a lower purchase price. Basically, will it be in a down market when I need to sell (in 5–7 years from now).
This approach is supported by economists projections that show increasing cap rates in the future. If your investment still shows good returns even if you sell it in a down market — than you are most likely to do well during a recession. This way, you are focused don the cash flow that the property is generating and not the future appreciation, which is not entirely known with high level of certainty.
Actionable advice for passive investors: ask the syndicator to share their exit cap assumptions and the purchase cap rate and compare the two — if the exit cap is higher or equal to the purchase cap, ask them why and use your knowledge of the market and your judgment to determine if it make sense.
Look at worse-case scenario — 0% rent increase
A significant part of any real estate deal, especially multifamily and office space, is rent increase. In a turn key deal, where no improvement to the property is needed, there is a certain rent increase that reflects the market trend, and is usually 2%-4%. That is to say, that the investor believes that because rents increase in the market, s/he will be able to do so as well. Some markets have a phenomenal rent increase, such as Orlando (with around 7% rent increase compared to last year). In a value add deal, the rent increase is projected based on investors assumption of post-renovation rent bumps. A rent bump of $75 — $150 per unit per month is pretty common with multifamily properties.
Rent increase significantly affects the projected returns of any deal. However, you should consider a scenario where rents have peaked and will no longer increase, which is a likely scenario in a recession. This will be a harsh reality for many investors, and especially since we already started seeing a decline in rent growth across the US. A recession-proof property is one that is still cash flowing even when the rents are steady.
When I analyzes a deal, I run multiple scenarios, including a scenario where rent growth = 0%. It’s important for me to see how lack of rent growth affects the returns, and if it’s still positive, then I know it is a good investment.
Actionable advice for passive investors: ask the syndicator for a sensitivity analysis with 0% rent growth and observe the returns in such case.
Look at the history — how did the area and the property perform in 2008?
Nobody knows how the next recession is going to look like, and hopefully the next part of the cycle will not be as severe as the previous recession, but looking into the history books of any investment will give us a better idea of how it will behave in the future.
Actionable advice for passive investors: before investing in a certain area, look up for information about how it during 2008 (even a Google search will be helpful). In addition, try to understand how the property performed during 2008; ask the syndicator what s/he knows about the property’s performance back in 2008 and ask to see financial reports from that period. You don’t have to be an expert to notice a loss in a P&L, and
it’s important to inquire about it before you make a decision to invest.
In order to ensure your investment is recession-proof, make sure that:
- cash flow is impacting the returns, not a high appreciation factor
- the investment is still solid even with no rent growth
The property was performing well even during the last recession