Given the recent stock market volatility, many real estate investors wonder, “Are we headed into a recession? How will that affect real estate? And how long is Brandon going to stay committed to that beard?”
The beard is a puzzle that’s baffled scientists for years—but when predicting how the next recession will affect your portfolio, history can be a guide.
Is Real Estate Recession-Proof?
This is a common misconception. Unfortunately, it’s not.
Many silly real estate investors who believed that myth got wiped out during the last recession. But the good news is that real estate can be recession-resistant. With proper precautions and an understanding of recession dynamics, you can prepare your portfolio to navigate choppy economic waters.
I had the great privilege of going through the horrific, Armageddon-like real estate collapse of 2008 with multiple properties. It was like a Michael Bay movie—people screaming in the streets, explosions, cars flipping over…
OK, not exactly. But it could’ve been if they’d have let him direct “The Big Short.”
I had six multifamily properties at the time.
Below I’ll walk you through the economic cause-and-effect patterns that impact rents, values, and the ability to maneuver (sell/refinance) during recessions.
The Pre-2008, 2008, and Post-2008 Investing Climates
It all started pleasantly enough…
I discovered real estate investing in 2000 and loved it. Everyone did. You couldn’t lose. That went on for seven years. Then, 2008 happened.
Lehman Brothers and Bear Stearns, two of the world’s largest investment banks, collapsed. The stock market plunged, and the financial world went into panic mode
These events then unleashed an economic chain-reaction. Below are several of the ways real estate was impacted.
1. Real Estate Investment Activity Ground to a Halt
Shell-shocked investors watched with fear, uncertain how long the economic slide would last. Values were at record highs prior to the crash, and many felt this was a long-time coming. The sense was that things could get a lot worse before they got better.
When investment stopped…
2. Construction Ground to a Halt
New construction projects, and many already in the pipeline, were put on hold. Investment dollars dried up, because the investors providing those dollars were reeling from their own losses. And confidence that new projects would get completed and be profitable was in doubt.
One thing was certain: The boom clearly over.
Ten million workers are employed by the construction industry. Many are project-based, not salary-based. So when the construction activity stops, a chunk of the labor pool becomes unemployed overnight.
Many other industries are impacted by the health of the construction sector.
Also… in boom years, there’s a tendency to overbuild.
You’d think that building would be based on need. But when the spigot of construction financing flows enthusiastically, no one’s there to monitor how much gets built and turn off the spigot.
The result is oversupply.
There’s a saying that goes, “Boom markets die from oversupply.” Another one goes, “Cranes in the air, investors beware.”
For some reason, there are a lot of cute rhymes about overbuilding. I think Dr. Seuss may have moonlit as a construction economist.
3. Banks Became More Conservative
The recession began with a spike in delinquencies and defaults, which turned into a tidal wave of foreclosures. Lenders who’d made risky loans started going bankrupt, culminating with the world’s largest lender at the time: Countrywide.
So, banks reacted by becoming more conservative, making it difficult for struggling property owners to refinance. And purchase loans were given much more scrutiny.
This conservative lending added to the market slowdown.
4. Renters’ Incomes Went Down
The stock market plunge and growing layoffs caused consumer confidence to drop. People were cautious and spent less. This caused corporate profits to go down, resulting in salary cuts and layoffs.
We were seeing a steady uptick in unemployment.
Many of those laid off were renters, who then struggled to pay rent. Many others were homeowners, struggling to pay mortgages. (I won’t go into the compounding effect of adjustable-rate mortgages, because it was specific to 2008. The intent here is to highlight general recession patterns.)
5. Renters Sought Cheaper Alternatives
Renters in high-priced, A-class apartments moved down to more affordable B-class units. Others moved in with friends, or back home with their parents. There was a “renter consolidation” that caused…
6. An Uptick in Vacancy
It was most pronounced in A-class properties, but it was felt at all tiers and exacerbated by the overbuilding of recent years. Much new construction tends to be A-class, because it’s the most profitable.
However, apartment vacancies were mitigated, because a new pool of tenants was entering the market…
7. Former Homeowners Became Renters
Job cuts caused many struggling homeowners to fall behind on their mortgages. Here’s yet another downer saying, “Recessions create renters.”
Not as catchy. It doesn’t even rhyme.
This brought some stability to multifamily occupancy levels.
But due to the confluence of factors—oversupply, lower incomes, investor fear, and tightened lending…
8. Property Values Declined
Single-family residences were hit the hardest. There were far more sellers than buyers.
Also, SFR values are based on buyer sentiment (or “emotional buyers”). The emotion had been irrational exuberance during the preceding years, but now it was fear.
Multifamily values were more stable, due to their income stream supported by leases. But that didn’t mean multifamily properties were in the clear.
Rent growth stalled, transitioning into rent declines in some locations hard-hit by the recession.
Additionally, unit class mattered. Rent drops were most precipitous in A-class, as many tenants could no longer justify paying top-of-the-market rents for luxury units. Many A-class renters relocated to B-class properties.
Meanwhile, to address the turmoil…
9. The Fed Stepped in and Lowered Interest Rates
It was an attempt to stimulate the economy, and it provided a lifeline for many property owners in trouble.
Owners who were not in trouble (aka were prepared for the recession) had an opportunity to refinance at rock-bottom rates, improve the health of their portfolio, and navigate out of the storm.
But the lenders were still reeling from their losses. And as values went down, they were enforcing the “maximum loan-to-value” clauseâa clause often forgotten in normal times because loan balances go down and property values go up.
But during recessions, when property values slide, borrowers who had been at max leverage (often 75 percent LTV) find themselves having to pay down their loan to meet the required LTV.
What does this mean?
Basically, if you bought a property for $1,000,000, and the lender’s max LTV (leverage-to-value) is 75 percent, they will give you a $750,000 loan. But if for any reason your property value drops to, say, $900,000, your $750,000 loan has now increased to 83 percent of value. So, the lender will require you to pay down the loan to get to 75 percent LTV.
$900,000 x .75% = $675,000
Therefore, you’d be on the hook to fork over another $75,000.
This happened to me.
I had to pay down a loan by $95,000 to meet the LTV requirement. The upside, however, was that due to the Fed’s rate cut, my interest rate went from 4.5 percent to 3.5 percent, and my loan balance was now lower—resulting in a big boost to cash flow.
And luckily, I had the reserves to make that $95,000 payment!
10. Where You Invested Mattered
Each market experienced the recession differently. The severity and recovery timeline varied depending on where you were. Markets with diverse economies were the most resilient.
Prices recovered sooner in major markets, as cautious investors sought the safety of top-tier markets.
Those top-tier markets then became the first where prices became overheated as the economy recovered, so investors moved on, seeking returns in secondary and tertiary markets.
And the whole cycle began again…
Key Takeaways from the Last Recession
- Don’t over-leverage. Especially late in a boom market.
- Be prepared for rent volatility. Many investors don’t realize rents can go down. But they do!
- Have reserves, and bolster your cash positions (no-brainer).
- Monitor the supply of new units being built in your market. (I make a point to invest in cities where it’s very hard to build.)
- Buying value-add helps—you can offset declining values through forced appreciation.
- Avoid A-class properties, or bolster those reserves. (I’m not anti-A-class, but I prefer to buy these premium assets coming out of a recession, when they’re beaten up and bargain-priced.)
- B & C-class multifamily is most stable (but not immune). This was my experience, and statistics seem to support it.
Rent Declines 2008-2010 and Rent Growth 2010-2018
I’m fortunate that all of my multifamily properties survived the 2008 recession. And yours can, too—just prepare!
I hope this was helpful and good luck!
Lee Ripma is a Los Angeles-based scientist-turned-real estate investor and entrepreneur....
What is loss to lease? If you’ve spent as much time around profit/loss statements as us, you’ve likely come...
Interest rates have been rising. Single family residence prices are softening. Does that mean we’re headed for a...
East Riverside SubmarketLocated just minutes from the Austin Central Business District, Oracle's new campus, and the...