How to Build a Real Estate Portfolio That is Recession-Proof
After more than 10 years of strong and steady economic growth, it appears that the good times may be coming to an end. While some investors may become nervous and sell their holdings and hold cash, other investors focus on real estate investments that actually perform well in a recession.
In this article we will discuss the how, what, and where of investing during an economic downturn, and reveal how to recession-proof a real estate portfolio.
Related: How The 10,000 Hour Rule Should Guide Your Real Estate Investment Decisions
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What is a Recession?
The traditional definition of a recession from the National Bureau of Economic Research (NBER) is a period where there is “significant decline in economic activity that is spread across the economy and lasts more than a few months.” Recessions also create high levels of unemployment which eventually declines as the economy recovers.
Recent U.S. recessions
Recessions in the U.S. follow the normal business cycle, beginning at the peak of the cycle and ending at the trough. Over the past 40 years there have been six recessions, according to the NBER:
1980 6 8%
1981 16 11%
1990 8 8%
2001 8 6%
2007 18 10%
2020 On-going 15%
Causes of a Recession
A recent post from The Brookings Institution reports that the coronavirus crisis, and the subsequent business closures, event cancellations, and the shift to working from home triggered the current recession that is continuing to this date.
Since 1857 the country has gone through 34 recessions of varying durations and causes. Some of the main drivers of recessions over the past 164 years include:
Deflation: Deflation occurs when prices and wages decline over time. Consumers and businesses stop spending, creating a negative feedback loop that leads to a recession. Since the 1990s, Japan has been fighting deflation and has yet to win the struggle.
Inflation: Inflation occurs when prices steadily increase over time and is often accompanied by a decline in the value of the dollar. During World War II, inflation reached a high of 20%, and in the late 1970s peaked at about 15%. Inflation has increased by more than 150% since 1980, as measured by the consumer price index (CPI).
Excessive debt: When too many consumers and businesses take on too much debt, defaults and bankruptcies that affect the economy can occur when debt servicing costs increase due to rising interest rates. In less than two years, the Federal Reserve’s balance sheet has doubled in size from $3.8 trillion to about $8 trillion. However, proponents of the Modern Monetary Theory (MMT) argue that governments can spend freely because by definition the government’s deficit is the private sector’s surplus.
Asset bubbles: Of course, too much surplus in the private sector can also lead to asset bubbles. Back in the late 1990s, Federal Reserve Chair Alan Greenspan remarked that outsized gains in the stock market were due to “irrational exuberance,” shortly before the bursting of the dotcom bubble in 2001. Since then, the S&P 500 Index has nearly quintupled in size, from about 886 in January 2003 to 4247 in June 2021.
What a Recession-Proof Real Estate Portfolio Should Include
If the NBER is correct, at time of writing we are still in the middle of a recession. Over the past 12 months, the CPI has increased by 5%, the median sales price of houses sold in the U.S. rose by 5.6%, and commercial real estate prices have grown by 11.5%.
While residential real estate prices have kept pace with the increase in inflation, the rise in commercial real estate prices is more than double the CPI. In fact, one of the biggest benefits of investing in commercial real estate is to hedge against inflation, along with the recurring income and appreciation in asset value over the long term.
Factoring Risk & Yield
Interest rates throughout this recession have remained at historic low. Low interest rates combined with a surge in money supply have pushed cap rates for major property types in the U.S. down to around 5% or less as yield-hungry investors desperately search for returns on investment.
While ROI can be increased by using higher levels of debt, investors should be careful to strategically balance risk with potential reward. Investing in projects with conservative loan-to-value (LTV) ratios and avoidance of speculative, high-risk investments may have lower rates of return but are also much safer should the economic recovery take longer than expected.
Protecting Your Portfolio
There are two key ways to protect your real estate investment portfolio during a recession:
1. Focus on cash flow. Even if property values decline over the short-term due to rising interest rates, good recession-resistant commercial real estate investments such as self-storage can continue to generate solid cash flow through all economic cycles. Month-to-month leases allow rents to be quickly adjusted to market. Retail sales of boxes and packing kits and tenant insurance are two of the many low-cost ways to boost self-storage revenues through value-add services.
2. Reduce debt. Property owners who have not yet refinanced should take the opportunity to reduce large loan balances with today’s low interest rates. While the Federal Reserve aims to control interest rates along the yield curve, there’s no guarantee that interest rates will always be this low.
Related: How Much Money Do You Need to Invest in Real Estate?
Not all types of commercial real estate generate the same ROIs or offer investors the same protection during a recession. Real estate in general is a good hedge against inflation and recession. However, self-storage investments were the only commercial real estate asset type to produce positive returns during the Great Recession of 2008, according to Trepp.
Investors with under-performing assets in their portfolios may wish to consider selling today while cap rates are low and prices are high. Investment capital can then be redeployed into property offering the best risk-adjusted returns, such as self-storage investment funds.
Where Should You Invest In a Recession?
Commercial real estate investments such as self-storage are known for being recession-resistant, but many people are surprised to learn that certain parts of the country are relatively recession-proof as well.
Conventional wisdom says that primary markets are the best places to invest, but during this recession that’s no longer the case. According to research from The Pew Charitable Trusts, states with large urban areas such as California, New York, and Illinois have lost the most population over the last two years.
One reason people are moving from the big cities may be due to the lack of jobs. As the most recent report from the U.S. Bureau of Labor Statistics reveals, California, New York, and Illinois are among the top 10 states with the worst unemployment rates (April 2021).
So where are the best geographic areas to invest in during a recession?
To find the most recession-resistant cities, financial technology company SmartAsset recently examined nine metrics such as unemployment rate, labor force participation, housing costs as a percentage of income, and state savings as a percentage of state expenditures.
Based on this data and methodology, the top 25 most recession-resistant cities are:
- Frisco, TX
- Cedar Rapids, IA
- Plano, TX
- Denton, TX
- Austin, TX
- Sunnyvale, CA
- Lubbock, TX
- Cary, NC
- Raleigh, NC
- Sioux Falls, ND
- Round Rock, TX
- Boise, ID
- Rochester, MN
- Lincoln, NE
- Arlington, VA
- Omaha, NE
- Madison, WI
- Durham, NC
- Arlington, TX
- Killeen, TX
- Oklahoma City, OK
- Fort Collins, CO
- Alexandria, VA
- Fargo, ND
- West Valley City, UT
What Should You Invest in During a Recession?
Real estate is arguably the best asset to invest in during a recession. But, it’s important to understand that some types of commercial real estate have performed better than others during this recession, according to the 2021 U.S. Real Estate Market Outlook report from CBRE.
In many markets across the country, the office and retail asset classes are still being impacted by occupancy declines, negative absorption, and effective declining rents. Work-from-home is becoming a permanent part of the way businesses employ people, with companies likely not needing nearly as much office space once the recession comes to an end.
While people are staying at home more, they are also shopping more online. Although the torrid pace of e-commerce growth has begun to stabilize, bankruptcies and store closures are still continuing. Anchor tenants such as grocery stores are still growing aggressively, but with so much vacant retail space on the market landlords are being forced to offer concessions to preserve occupancy.
On the other hand, industrial and alternative investments including data centers, student housing, and self-storage historically offer protection during a recession. Alternative investments such as self-storage generally have higher yields, more stable cash flows, and offer investors the diversification they need during an economic downturn.
Diversification is one way to protect your real estate portfolio during a recession. Diversifying holdings can be accomplished in a number of ways, such as by asset class, geographic location, and investment strategy.
For example, investors who traditionally hold real estate directly may wish to consider participating in a private equity investment fund designed to purchase self-storage investment across the U.S. Passive investments like these offer diversification through asset class and geography, helping to reduce investment risk during a recession.
What to Invest In
CBRE Research predicts that over the next few years there will be up to a 20% reduction in total U.S. retail real estate inventory. Of the 4.2 billion square feet of retail inventory in the U.S., about 840 million square feet will be converted into uses that meet the highest and best use of the underlying land and demand, including multifamily, industrial, and self-storage.
In fact, self-storage can be a very logical reuse for big box retail space. Obtaining approval for a self-storage redevelopment project can be easier than a new project for experienced self-storage developers and operators.
But not every vacant shopping center is a good match for conversion into self-storage space. The existing building should have a large floor print, adequate parking close, be close to residential areas, and have good drive-by traffic from nearby businesses such as a home improvement store or grocery.
Where You Should Put Your Money in a Recession
Investors should focus on commercial properties that generate regular lease payments through all stages of an economic cycle, especially during a recession. Passively investing in self-storage opportunities can generate bond-like yields through regular distributions, along with a potential increase in property value over the long term for the buy-and-hold investor.
While commercial properties are more expensive than smaller residential investments during a recession, it’s also possible to find some very attractive deals when one knows where to look. During a recession, lenders are often reluctant to provide financing to inexperienced investors. That’s why placing capital in a private equity deal as a passive investor can be a better way to invest.
In fact, during a recession many commercial real estate investors rely on joint ventures, private equity deals, and syndications to find the best opportunities for the most robust returns.
Recession-resistant investments such as self-storage often see a significant increase in demand from consumer and business tenants during economic downturns, as families free up space for a home office and companies store unused office furniture and fixtures.
Smart Investment Strategies During a Recession
There are several key strategies to follow to generate the best returns when investing in real estate during a recession:
- Choose properties that will generate consistent cash flow from rental income with short-term leases allowing rent to be easily increased to the market rent.
- Make the most of an illiquid investment such as real estate by buying and holding for the long term while profiting from regular recurring income.
- Offering tenant amenities such as temperature controlled storage units and secure 24-hour access can help keep tenant turnover low and occupancy levels high.
- Value add services such as retail sales, tenant insurance, truck rentals, and tiered pricing can maximize value in a self-storage property with little or no increase in operating costs.
Related: Death, Taxes, and Other Reasons to Invest in Self-Storage
When building a real estate portfolio that is recession-proof be sure to take into account key considerations such as risk and yield, cash flows, and reallocation of investment capital to assets that are recession-resistant such as self-storage. Diversifying investment is also important during an economic downturn. Some commercial real estate asset classes, such as industrial and alternative investments like self-storage, historically perform exceptionally well through all stages of the economic cycle.