What Drives a Recession and Why is it Important to You?
By Clifford Hockley, Principal Broker
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 the following:
- Increased fuel costs and worldwide lack of access to fuel;
- Rising interest rates;
- Money is being funneled out of the US economy toward the Ukraine conflict; and
- The lack of employees for open jobs is 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 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 slow to half a percentage point — and eventually a quarter point. (3)
- The New York Times November 2, 2022, Edition, reinforced the significant employee shortage that is being felt throughout the United States. “The nations 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 because higher interest rates drive the inverse of lower values as the increased cost of indebtedness makes it more difficult for properties to cash flow. Additionally, as interest rates increase there is lower demand for homes. In order to create demand, sellers reduce the pricing of their homes to sell them. Developers in particular 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. (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% over your current payments as mortgage adjustments occur.
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
What stamps a recession out is increased spending. That is difficult to do when we are short over 10 million employees in our workforce to help us spend.
Some investors will wait out the interest rate increases before they purchase more real estate, to allow sellers and lenders 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 shopping malls have significant vacancy rates and may be foreclosed on. Some developers are looking at these buildings as redevelopment opportunities.
A national syndicator told me recently that they are storing up money to be ready 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 a selling opportunity. This may affect net worth statements as pricing is adjusted downward. That is why paying attention and talking to lenders and brokers is critically important as we find our way through the next few years.
We are facing a dynamic economy – funded by climate change driven programs and federal projects funding infrastructure to reset and focus on an economy designed to use electricity rather than hydrocarbons (oil) or coal, the Ukraine war, and demographic changes. This will balance the interest rate increases that are designed to slow down the economy and thereby reduce the rate of inflation.
Ever increasing interest rates create an environment of uncertainty for real estate investors. In some cases rents will go up, in others rents will go down. With an economy grinding to a slow halt, investors are facing difficult decisions regarding their investments. Owners of non-performing properties are facing significant downward pressure on their real estate investments and will have to decide how to position themselves. Sellers are finding their property values dropped significantly as CAP rates have adjusted to the marketplace. The best short-term recommendation is to have lots of cash available to be prepared for increased interest and vacancy rates. (7)
“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 with more debt are forced to cut costs more aggressively, which limits the cash available to fund growth.” (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/
(6) https://www.yahoo.com/video/recession-may-just-prove-great-113822588.html
(8) https://hbr.org/2019/05/how-to-survive-a-recession-and-thrive-afterward