The economy, including the real estate market, operates in cycles. There are periods of growth and economic expansion, followed by an economic slowdown. However unwelcome an economic or real estate recession may feel, it's a natural part of our country's real estate cycle.
Learn what happens during a recession and how they can impact the real estate industry, what opportunities are present during an economic downturn, and who typically benefits during a real estate recession.
What happens during a recession?
During a recession, the economy retracts and economic activity is slowed. Typically:
- Gross domestic product (GDP) growth decreases.
- Unemployment increases.
- The financial market, including the stock market and real estate, experiences price volatility.
- Banks and lending institutions strengthen their lending criteria, making it more difficult to get a mortgage and possibly reducing the number of loans being offered.
- New housing starts or new construction halts.
- The government intervenes, increasing the national debt.
- The Federal Reserve may lower the federal rate to promote lower mortgage rates.
Recessions are caused by different factors, and what caused a recession in the past is not necessarily what may cause one today. For this reason, markets, like real estate, will be impacted in different ways depending on the cause, the severity, and the longevity of the recession.
Does an economic recession imply a housing recession?
Not all economic recessions mean the housing market will crash. The Great Recession, which started as a result of the subprime mortgages and mismanagement of mortgage-backed securities, caused real estate housing prices to fall by 30% to 50% in a matter of months.
A housing recession to this magnitude had never been seen before and has caused many to believe that a recession in general means that all markets will plummet as they did in the 2008 financial crisis. But that's not the case.
A real estate downturn can be caused by many factors including:
- Affordability, when prices have been pushed so high homes are no longer affordable. As a result, values go down because demand has decreased as no one can afford to borrow or buy.
- Waning demand, from an oversupply, lack of interest, or little to no economic activity in a certain market or sector of real estate.
- False demand, from mortgage rates being low for too long or from loose lending policies making it easy to get a mortgage (like what happened in the Great Recession), creating a high demand for housing.
- A severe economic recession, which lowers the demand for housing because consumers are motivated to save versus spend because of high unemployment and volatility in the market.
What does a recession do to real estate?
In general, a recession typically causes real estate values to decrease because there is a lower demand for homes or investment properties. It can cause vacancies to increase because people may experience a loss in wages or become unemployed and rental rates decreases because tenants are less likely to rent a new unit or move during this time. Short sales and foreclosures increase because people have difficulty paying their mortgage.
While the example above is a common outcome, it's important to note that certain types of real estate will be impacted differently based on the cause of the recession and the health of the real estate market and sector. For example, in today's market (at the time of this writing), real estate in many metro markets is considered overpriced, where appreciation rates and home values are not supported by wage growth.
Other markets have an oversupply of certain real estate sectors. They may have too much commercial real estate, like retail space, high-end apartment complexes, or self-storage units, as an example. When the housing market tightens, these markets and sectors will be hit the hardest.
Who benefits the most during a real estate recession?
Those who do the best during a recession are those who have equity in their home or investment property, high liquidity, and sufficient cash flow or cash reserves to pay their debt obligations, even if there is a reduction in cash flow or income for a short period of time.
Since lending is often restricted in a recession, getting a mortgage from a traditional lender may not be an option. So, real estate investors and homebuyers who have the capital to buy real estate when values are low will benefit the most.
How real estate investors can prepare for a recession
In the event that a recession seems likely, investors should plan to reduce their debt obligations. If you are overleveraged, try to sell certain assets to increase your liquidity and have a surplus of cash on hand in case you suffer a loss of income. Also evaluate the health of the local market and the supply and demand of your asset classes. Nothing is truly recession-proof, but in most cases, diversification across different investment classes will help reduce your risk exposure and limit your losses in a downturn.