If you’ve turned on the television or opened a newspaper lately, you’ve likely heard one word over and over: recession. Due to a variety of factors, the US economy is facing a downturn. In particular, this current economic situation combines two damaging phenomenons, inflation and a slowing economy. This reality begs the question, how should real estate investors approach multifamily investing during a downturn?
We’ll answer this question and discuss additional considerations in the following article. Specifically, we’ll cover these topics:
- Advantages to Multifamily Investing During a Recession
- Potential Concerns with Multifamily Investing in a Recession
- Final Thoughts
Advantages to Multifamily Investing During a Recession
Increased Demand
Traditionally, as the economy slows, demand for apartments increases. Due to a combination of layoffs and inflationary pressures, recessions limit the amount of disposable income people can use for housing. As a result, more people who would normally look to buy a home are forced to continue renting. Furthermore, people who do own starter homes may have to sell and return to renting.
Both of the above factors increase demand for multifamily rentals. Accordingly, many multifamily investments serve as a countercyclical hedge. That is, as the economy slows, demand – and by extension, operating performance – of apartment buildings increases. Whereas traditional investments like stocks generally track the economy up and down, multifamily performance tends to stay strong while the economy sinks.
Debt Service as an Inflation Hedge
As stated, the current downturn facing the US economy also involves significant inflation. In simple terms, inflation means that your dollars will buy less tomorrow than they do today. While inflation hurts purchasing power, mortgages on multifamily properties hedge against this drawback.
When investors secure a permanent loan for a multifamily property, the principal and interest portions of those payments remain constant for the life of the loan. (NOTE: If paying insurance and real estate taxes into lender escrow, those portions of your mortgage payment will generally increase with inflation).
Say, for instance, you pay $20,000 in principal and interest every month. After a year of high inflation, you will still pay $20,000. However, that money will have far less purchasing power. In other words, you will make future loan payments with “cheaper” dollars due to inflation, providing multifamily investors a hedge in these sorts of economic downturns.
Potential Concerns with Multifamily Investing in a Recession
Rising Interest Rates
Unfortunately, we’re currently dealing with a “perfect storm” economic situation, with a stagnating economy and rapidly rising inflation – a situation known as stagflation. To combat rising prices, the Federal Reserve (“the Fed”) increases interest rates. In theory, increased borrowing costs slow down the economy, which in turn should slow down inflation.
However, these Fed actions have a knock-on effect with mortgage interest rates, forcing them up as well. Small increases in borrowing rates can have large effects on the debt costs. Two to three percentage point increases in borrowing costs – which we’ve seen over the last year – can have enormous effects on debt costs.
For example, say you need a $1,000,000 loan for a multifamily investment. Assuming a 10-year term and 30-year amortization, increasing your interest rate from 3% to 5.5% leads to: 1) a $1,482 increase in monthly payments, and 2) $154,373 increase in total interest paid over the 10-year term. These massive jumps can quickly turn a profitable deal into an unprofitable one.
Increased Costs of Construction
In addition to affecting daily purchases (e.g. gas, food, electricity, etc.), inflation also drives up construction costs. These increased costs translate directly into more expensive new multifamily projects.
For instance, assume a given market averages $200/square foot in multifamily construction hard costs. Now, say that those costs increase by 10% due to inflation. For a 40,000 square foot new apartment building, the original projected hard costs totaled $8,000,000. With the 10% increase, those hard costs increase by $800,000. To mitigate these increased costs, investors need to bring more cash to the table, decreasing the deal’s overall returns.
Final Thoughts
While reading about economic recessions gives many investors the chills, real estate can mitigate your risks. Yes, inflation can provide some challenges. But, in general, smart investments in multifamily assets offer a way to counterbalance your portfolio as the broader economy contracts. Investing in already stabilized multifamily projects provides benefits while avoiding inflationary drawbacks, as these properties 1) have already locked in lower interest rates, and 2) avoid increased costs of construction.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available passive multifamily investment opportunities – and how they can help you weather economic storms!