What Real Estate Investors Need To Know About a Recession Market
The moment the Federal Reserve announced its intention to raise the federal funds rate to rein in inflation, analysts started warning that a recession might be on the way. They’re not wrong to sound the alarm – it's not the first time the Fed has raised rates to combat inflation, and on at least five occasions in the past, a recession followed.
But it's hard to say exactly when or how severe the next one will be. Some experts think a recession is likely in 2023, but no one really knows for sure. This uncertainty makes things difficult for real estate investors trying to plan for the future.
While predicting a recession requires a crystal ball—a little knowledge goes a long way. A little insight can help investors make more informed decisions in the coming year and beyond.
What is a recession?
Alright, let's break it down. A recession is basically a period when the economy is shrinking, and trade is slowing down, leading to a decrease in the gross domestic product (GDP). To be technically accurate, it's when GDP has two consecutive quarters of negative growth. Avoiding a recession is not as simple as it sounds. Keeping the economic engine running smoothly takes a lot of stability and certainty. Too much uncertainty or turmoil can cause the system to break down and make it difficult to avoid or recover from a recession.
Let's look at what happened when COVID-19 hit the US in February 2020. All of a sudden, everything changed overnight, and people and businesses were told to stay home and avoid contact with others (instability). Nobody knew how long it would take for things to go back to normal (uncertainty), and this caused economic activity to come to a grinding halt. As a result, we went into a recession, and GDP dropped by almost 20%, with unemployment hitting 14.7%.
But hey, there's a silver lining! Thanks to technology helping businesses adapt quickly to the lockdowns and the government stepping in to limit the damage, the pandemic recession was relatively short-lived, lasting only from February to April 2020.
How did we get here, possibly facing a recession in 2023?
Alright, let's chat about what the government and the Federal Reserve did to keep things moving during the pandemic. It was pretty great because it helped businesses and regular people keep their heads above water and kept things from getting worse. But, unfortunately, it's also why there's been such buzz about another potential recession.
To combat COVID-19, the government pumped a whopping $5 trillion of federal stimulus into the US economy in 2020 and 2021. And on top of that, the Fed cut the federal funds rate to almost zero, increased lending, and started buying up many mortgage-backed securities to prevent the housing market from crashing.
Alright, let's break this down. As the pandemic forced people to cut back on things like travel and entertainment, they started saving more money than usual, and that trend continued throughout 2021.At the same time, unemployment rates dropped from 6.7% in December 2020 to 3.9% by the end of 2021, meaning wages increased across the board.
When vaccines became more widespread, people were eager to spend their newly-acquired savings and higher wages, so they started dining out, taking trips, and upgrading their cars and homes (where we're all spending a lot more time these days). But this sudden surge in demand put a spotlight on the pandemic's global impact on industries like mining, manufacturing, and logistics. And when supply couldn't keep up with demand, prices for things like lumber and dishwashers went through the roof. In fact, by January 2022, inflation had hit a whopping 7.5%, which was more than five times higher than the year before.
To help bring inflation under control, the Fed began raising interest rates in March 2022, and they've continued to do so seven more times since then. Depending on when you're reading this, interest rates may have shifted, but as of now, they're hovering between 4.5% and 4.75%. The good news is that the Fed's approach seems to be working, and inflation has dropped from a high of 9.1% in mid-2022 to 6.4% as of January 2023.
Reducing inflation is definitely a good thing, but it's not a total win just yet. The inflation rate might have come down to 6.4%, but that's still way higher than what we were used to seeing in 2019. The Fed isn't planning on stopping its interest rate hikes until the inflation rate gets closer to 2-3%, and they want to keep rates high until they're sure that inflation won't spike up again.
Their goal is to achieve a "soft landing," which basically means bringing down inflation without causing a recession. This would be great news for everyone, especially for rental property investors, but there's no guarantee that things will turn out that way.
The soft landing scenario: a recession is not guaranteed
While many experts believe it will be impossible for the Fed to pull off a soft landing, recent metrics offer a glimmer of hope. Unemployment hit a 54-year low in January, consumer sentiment reached a 13-month high in February, and the fourth quarter of 2022 GDP rose a higher-than-projected 2.9%, leading one well-known economist in particular to voice his support for this scenario.
“There's a lot of risk given the high inflation and the Federal Reserve’s very aggressive efforts in raising rates to try to quell that inflation,” Moody’s Analytics Chief Economist Mark Zandi was recently quoted as saying. “But, you know, if I had to pick a side, recession, no recession, I think there's a good fighting chance that we'll get through the next 12-18 months without an outright recession.”
The short and shallow recession scenario
So, a lot of people are wondering what kind of recession we might be looking at if the Fed can't manage a "soft landing" for the economy. In his interviews, Zandi left open the possibility of a “very, very mild recession.” Most analysts think it'll be a pretty mild one, and there's some historical evidence to back that up.
The Fed has used interest rates to control inflation five times since 1959, and in four of those instances, unemployment was already pretty high going into the recession. But the one time they caused a recession when unemployment was low, it was mild and didn't last very long at all. In fact, it only lasted 11 months back in 1969-1970, and GDP only fell by 0.6%. Right now, unemployment is at 3.4%, which is actually lower than it was heading into that last mild recession.
So, what does this mean for rental property investors? Well, on the one hand, if there is a mild recession, home prices might come down a bit more, making it easier to buy properties. But on the other hand, it could also bring a lot more competition from other investors and home buyers looking for a good deal. So, if you're thinking of getting into the rental property game, you'll want to be ready to move quickly if a mild recession does hit.
The deep and long recession scenario
Let's talk about recessions for a minute. We’ve looked at an example of a recession that was deep but brief (-19.2% GDP, two months) and one that was a bit longer but very mild (11 months, -0.6%). And then there was the Great Recession, which was a real doozy.
GDP fell by 5.1% over 18 months, caused by the bursting of the housing bubble, not the Fed's policy. Plus, the landscape leading into that recession was different, with inflation about a third lower and unemployment about 40% higher in November 2007 than today.
The good news is that most experts think a severe and prolonged recession is unlikely, especially since the economy is pretty strong. If we do see a downturn, it'll probably be because of something happening outside the country, like a major conflict with Russia or China.
Now, as rental property investors, we should keep in mind that there's a housing shortage in the U.S. right now - we're talking a housing deficit of as many as 6 million homes. So even if there is a recession, people will still need a place to live. Of course, any downturn will still be damaging for a lot of people and businesses.
But if the Fed is forced to lower rates quickly, we could see a bigger drop in home values, which could present an opportunity for investors with cash or financing. After the Great Recession, a lot of investors were able to expand their portfolios this way.
Conclusion: Plan for what you can expect, and you’ll be better prepared for what you don’t
As a rental property investor, you might wonder what to do in this uncertain economic climate. Here's what appears certain — interest rates are likely to stay high for most, if not all, of 2023, and competition for properties will be fierce once the Fed starts to lower rates.
But here's the thing — rental properties are a long-term investment that will keep on producing income long after recession hand-wringing has ended. In fact, acquiring rental properties is a great way to hedge against the next recession, as rents remain relatively stable during downturns.
So, what should you do now? You may want to keep an eye on the same economic indicators that the Fed is watching and be ready to pivot your strategy if things start to change. It could also be a good time to explore financing options now to be ready to act when the time is right.
Remember, investing in rental properties is a marathon, not a sprint. Keep a cool head, stay informed, and you'll be in a good position to weather any economic storm that comes your way.
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