So, what happens to real estate in a recession? How much is the real estate market as a whole affected? And, the question on your mind is probably, when is the right time to invest in real estate?
To find out these answers, we’ll look at previous recessions, which will prompt you to identify where the market currently is in its cycle. This can help you look forward to the next few months or years and know when it’s the right time to buy again.
What is a Recession?
When the economy shrinks for at least 6 months or two quarters out of the year, the negative growth is called a recession. The GDP (Gross Domestic Product) represents the total value of goods and services sold within a country. A recession is when the GDP goes down for at least six months consecutively. When GDP returns to pre-recession levels, that marks the end of the recession.
A few red flags that a recession is happening or is very close are spiked unemployment rates and erratic stock market fluctuations. Experts often look toward history and point to traits of the Great Recession of 2008 or even the Great Depression in the early 1930s. However, most recessions are substantially milder than those.
By examining and understanding recessions and the sequence of events that occur before, during, and after a recession, you can purposely create life-changing wealth during the recovery period.
Where are we now, what should we expect, and when should we buy?
Based on previous recessions, here’s what could happen to real estate during the next recession and recovery cycle. Track your current experience and research of the US economy in comparison to the below stages, and you’ll be prepared when it’s the right time to invest.
Stage 1 – Unemployment Rates Increase
In the earliest stages of a recession, as I mentioned previously, unemployment rises. This is one of the big waving red flags that trouble is on the horizon. Businesses begin to feel the effects of fewer goods and services being exchanged (remember GDP?) and may close their doors or choose to furlough or lay off employees.
During the Great Recession of 2008, 2.6 million people were unemployed and during 2020, during the COVID-19 pandemic, the US hit an astounding historic unemployment record of 30 million people.
Stage 2 – Government Stimulus
As we’ve seen in recent history (2008 and 2020), the government may step in with a stimulus in an attempt to boost the economy with cash. Sometimes programs are offered to keep businesses afloat, sometimes eligible households are sent currency, and sometimes all of the above.
However, stimulus checks are a temporary band-aid that gets cash into the hands of Americans to encourage spending. This is why, for the first couple of months of a recession, rents are still paid. But what happens when people are still unemployed and they’ve spent their stimulus money?
Stage 3 – Loan Defaults
The longer businesses continue to close and consumer spending decreases, the more likely we will see loan defaults. As tenants are unable to pay rent, real estate owners deplete their reserves, and this results in a wave of defaults for residential and commercial loans.
As defaults occur, banks start to take over the properties, which brings us to the next step.
Stage 4 – Bank REO
When loan defaults occur, banks foreclose on those properties. Then, a wave of bank REO (real estate owned) properties appear on the market.
Since banks aren’t in the business of property management, they are anxious to sell these properties quickly at a discount. At this point, real estate investors should be ready with their checkbooks.
Stage 5 – BUY!
In examining the real estate pricing cycle of the recent past, we saw peak market prices in 2019, and we saw them again in late 2021 and early 2022 before interest rates began to rise. So, when will bank REO properties begin to hit the market?
This depends on several factors, including the speed at which the real estate market reacts, which is slow. Examine the historic trends – notice the “bottom” of the recession versus when REO properties become available. There could be years between these two events, which means patience is key.
Stage 6 – Inflation
A rise in inflation is the inevitable final stage of the recession cycle. Inflation is the result of additional money being flooded into the economy (remember stage 2?) and ultimately devalues the dollar.
This is precisely why the same dollar buys much less now than it did 10 years ago AND what makes real estate such a great investment. Real estate investments are a hedging bet against inflation, especially if they’re locked in with fixed-rate loan payments for about 30 years.
As the value of your currency decreases, your mortgage payments remain the same (if the loan is fixed rate) and your real estate values appreciate.
However, even real estate purchased with variable or floating rate loans can hedge against inflation, if the buyers plan for potential interest rate increases.
And, when inflation gets out of control, interest rate increases are one of the major tools the Fed uses to slow the inflation rate down. Of course, that has the effect of contracting the economy, so it can potentially lead right back into a new recession cycle.
What Happens if You Own Rental Property When a Recession Hits
During stages 1 and 2, tenants who lose their jobs may become unable to pay their rents. You may have to file for eviction, or they may break their leases early or skip out. This means apartment owners or owners of single-family home portfolios may see rising delinquency and have to write off more bad debt than usual.
It may become harder to sign new leases with qualifying prospective tenants. If that becomes a trend in the local market, then rent growth could slow, stall, or even decline somewhat, and owners may have to offer higher concessions to entice prospective residents to rent at their properties.
Tenants who need to tighten their belts might move into more affordable housing – for instance, residents in luxury Class A properties may move down to Class B, Class B residents may move into Class C workforce housing, and Class C residents may move to even more meager options or combine households with relatives or friends. These trends can increase a property’s vacancy. Class B properties tend to be the most insulated here, since Class A residents may downgrade to Class B. Class A properties tend to experience higher vacancy in a recession.
The combination of higher delinquency, bad debt, and vacancy, as well as negatively-trending rent levels and higher concessions, means lower income for the property. This, in turn, lowers the property’s value. Additionally, if investor/buyer demand slows, cap rates may begin to rise, lowering property values even more. The ultimate effect of this on a particular property depends on the current value and what the original purchase price was (a property’s value may lower, but still be higher than what it was purchased for).
Related Article: What You Should Know About Cap Rates as a Passive Investor
So What Can an Owner Do?
In this case, the most important thing is to be able to cover the debt service (loan payments) and meet the requirements of the loan. The owner needs to conserve cash. That may mean reducing expenses as much as possible, stopping capital improvements, and suspending distributions to investors (and themselves). Buyers should have sufficient capital reserves when they first buy a property to be able to continue operations, and should be able to contribute additional funds to the property if necessary to keep it afloat.
What You Should Do Now
Investing, market cycles, and our own individual experiences with these things mean some degree of guaranteed uncertainty. However, by examining history and economic fundamentals, we can have a better idea of when each stage presented above will occur.
On the tail-end of a recession, during the recovery, it’s likely that you’ll see an unprecedented number of deals flood the market and you want to ensure you’re ready.
In the interim, the best thing to do is focus on education and mindset, in addition to readying your personal financial situation so that when a deal hits, you can confidently invest.
And – if you’re investing in syndications as a passive investor – get to know how the sponsors you’re considering investing with prepare for a possible recession. How well do they capitalize their properties? What type of loans are they using? If they use floating rate loans, how are they hedging against possible interest rate increases? And what is their team’s overall liquidity?
To learn more about passive real estate investing and how to invest in upcoming real estate syndication deals join BluSky Equity Partners by signing up for our BluSky Investor Club.
Further Reading: How to Weather a Storm — 5 Ways to Diversify for Long-Term Growth