What drives a recession and why it is important to you

Dec 1

In economics, a recession is a business cycle contraction when there is a general decline in economic activity. Recessions generally occur when there is a widespread drop in spending (1).

What is driving us toward an economic contraction?

The primary factors driving us toward an economic contraction include:

Increased fuel costs and worldwide lack of access to fuel.
Rising interest rates.
Money being funneled out of the US economy toward the Ukraine conflict.
Employee shortage driving higher wages.

What to consider as you decide on your options

The Federal Reserve has decided that the economy needs to slow down due to increased inflation. As a result, the Board of Governors voted unanimously to raise the interest rate paid on reserve balances to 3.9 percent on November 2, 2022. More importantly, they also indicated more increases were to come (albeit smaller ones), as a result of continued employment strength. This is the highest funds rates have been in about 14 years (2).
Fed Chair Jerome Powell signaled that officials will likely take interest rates even higher than the 4.5-4.75 percent they initially projected in September, but might take smaller steps to get there. That could mean rate hikes worth half a percentage point or more (3).
The New York Times 11/2/2022 edition reinforced the significant employee shortage that is being felt throughout the United States: “The nation’s extreme shortage of job seekers worsened in September, the Labor Department reported […] Employers had 10.7 million positions open as the summer ended, up from 10.3 Million in August. That left roughly 1.9 posted jobs for every unemployed worker” (4).

Reduced Property Values

In general, a recession typically causes real estate values to decrease; higher interest rates reduce property values as the increased cost of indebtedness makes it more difficult for properties to cash flow.

In order to create demand, sellers reduce the pricing of their properties. Developers are hurt in a significant way as the cost of construction increases in addition to the cost of financing, making their product more expensive. Their risk increases if rents do not increase in sync with the market that sells them (5).

A major side effect will be difficulty in refinancing

As you plan for the future, you may be stuck with interest rates that are more than twice what you had in place a year ago, increasing the cost of your mortgage payments by at least 40%.

This is a good time to examine your existing loan terms to make sure you are not facing a huge, unexpected interest rate increase. Timing is everything.

Opportunity

Increased spending can stamp out a recession, but is difficult when we are short over 10 million employees in our workforce to help us spend.

Many investors will wait out the interest rate increases before they purchase more real estate to allow sellers and lenders (the marketplace) time to adjust their pricing. That being said, real estate is a very solid recession-resistant investment, and some opportunities will appear. The investment advisor Cohen & Steers Capital Management, Inc., recently indicated “Superior returns in real estate tend to follow recessionary periods” (6).

Foreclosures?

Most properties are operating successfully, but office buildings, especially in Central Business District (CBD) locations and large regional shopping malls, have significant vacancy rates and may be foreclosed on. Some developers are looking at repurposing these buildings.

A national syndicator told me recently that they are storing up money to purchase real estate foreclosures they expect to appear. There may be a spike in foreclosures that will mainly be the result of the expiration of the COVID-19 foreclosure limitations.

What Next?

Given that investors are motivated to find a way to make money, the market will adjust over time to create opportunities for investors. Buyers exist, and sellers will readjust their sights to create selling opportunities. In the meantime, net worth statements may be affected as pricing is adjusted downward. That is why paying attention and being in constant communication with lenders and brokers is critically important as we find our way through the next few years.

Summary

We are facing a dynamic economy. While there is an employee shortage, there are several federal programs, including climate change and infrastructure projects, that will continue to generate jobs.

Ever-increasing interest rates create an environment of uncertainty for real estate investors. In some cases, rents will go up, and in others, rents will go down. When the economy grinds to a slow halt, investors face difficult decisions regarding their investments.

Owners of non-performing properties will face significant downward valuation pressure on their real estate investments and will have to decide how to position themselves. CAP rates are adjusting upwards to justify higher interest rate costs. The best short-term recommendation is to have lots of cash available to be prepared for increased interest and vacancy rates (7).

As the Harvard Business Review says, “When a recession hits and less cash is coming in the door, it puts you at risk of defaulting.” To keep up with payments, companies and property owners with a large debt load may be forced to cut costs aggressively and refinance their short term positions to maintain solvent (8).

Sources

(1) https://en.wikipedia.org/wiki/Recession

(2) https://www.forbes.com/advisor/investing/fed-funds-rate-history/

(3) https://www.bankrate.com/banking/federal-reserve/how-much-will-fed- raise-rates-in-2022/

(4) https://www.nytimes.com/2022/11/01/business/economy/job-openings- economy-labor.html?searchResultPosition=1

(5) https://www.upnest.com/1/post/buying-home-during- recession/#:~:text=In%20general%2C%20a%20recession%20 typically,for%20homes%20or%20investment%20properties

(6) https://www.yahoo.com/video/recession-may-just-prove- great-113822588.html

(7) https://www.theguardian.com/commentisfree/2022/jun/16/is-the-us- heading-for-a-recession-heres-what-you-need-to-know

(8) https://hbr.org/2019/05/how-to-survive-a-recession-and-thrive- afterward

Clifford A. Hockley, CPM, CCIM, MBA

Cliff is a Certified Property Manager® (CPM) and a Certified Commercial Investment Member (CCIM). Cliff joined Bluestone and Hockley Real Estate Services 1986 and successfully merged that company with Criteria Properties in 2021.

He has extensive experience representing property owners in the sale and purchase of warehouse, office, and retail properties, as well as mobile home parks and residential properties. Cliff’s clients include financial institutions, government agencies, private investors and nonprofit organizations. He is a Senior Advisor for SVN | Bluestone.

Cliff holds an MBA from Willamette University and a BS in Political Science from Claremont McKenna College. He is a frequent contributor to industry newsletters and served as adjunct professor at Portland State University, where he taught real estate-related topics. Cliff is the author of two books, 21 Fables and Successful Real Estate Investing; Invest Wisely Avoid Costly Mistakes and Make Money, books that helps investors navigate the rough shoals of real estate ownership. He is the managing member of a real estate consulting practice, Cliff Hockley Consulting, LLC., designed to help investors and commercial brokerage owners successfully navigate their businesses. He can be reached at 503-267-1909 , Cliffhockley@gmail.com or Cliff.Hockley@SVN.com.