What Causes a Recession?
Updated: Aug 23, 2022
Is the US headed for a recession?
This seems to be the question on the lips of every economist and reporter.
With every pundit and Twitter economist screaming that a recession is coming, you might be wondering where that leaves you as an apartment investor.
Americans are no stranger to a recession. In fact, there have been five notable recessions in the last four decades. While real estate tends to be market specific, many investors make the mistake of not understanding how a recession would impact their real estate investments.
Do you remember what it was like during the 2008 Financial Crisis? Do you know what caused it?
Understanding the factors that contribute to an economic downturn is important for every apartment investor. This can help you make savvy investment decisions, and protect your wealth.
In this article, we’re diving into the different causes of a recession, and how you can identify the signs of a recession. We’re also explaining how a recession impacts apartment investors.
What exactly is a recession?
A recession is a major, extensive, and extended decline in economic activity. Recessions tend to last longer than 6 months, and a popular rule of thumb to classify a recession is that it must involve at least two consecutive quarters of decline in a nation’s Gross Domestic Product. Another definition for a recession used by economists at the National Bureau of Economic Research is a period of economic contraction beginning at the peak of the previous expansionary period and ending with the lowest point of the current downturn. Simply put, an economic recession is an extended period of economic decline.
A recession is typically accompanied by a decrease in economic output, consumer demand, and employment. While a recession can last for as little as a few months, it can take a nation years to fully recover from it. This period of recovery tends to involve economic hardships, including high unemployment.
Recessions are part of every economic cycle in a capitalist economy. With every boom, there is a bust. Recessions generally follow periods of strong growth (aka a boom). During a recession, some businesses may shrink or fail entirely. A decline in prices is also common in a recessionary period. However it is possible for prices to rise during a recession, as seen during periods of stagflation (sound familiar?).
What causes a recession?
There are a multitude of factors that can cause a recession. For one, a sharp increase in prices and inflation can result in a recession. In response to the COVID-19 pandemic, central banks across the world resorted to mass printing of their currencies. As a result, consumer’s purchasing power declined, and prices rose. Virtually everything increased in price.
The Federal Reserve is responsible for controlling inflation. In March 2022, they increased interest rates. Now, you might be asking yourself, what does this resolve? Well in theory, increasing interest rates should increase the cost of borrowing money, which will encourage people to stop spending. But inflation continued to rise.
A stock market decline can also cause a recession. The loss in wealth from a stock market crash can have major negative ripple effects on an economy. Economic uncertainty can permeate the consumer population and companies. If they become nervous, they may choose to liquidate their assets, which can result in even more market volatility. Pessimism and fear among consumers and investors can lead to the collapse of market bubbles and aggregate demand. All of these factors can exacerbate the negative impacts of a recession.
A sudden economic shock can also cause a recession. In the 1970s, for example, the sharp increase in the price of oil caused an economic downturn. The coronavirus pandemic and the government’s ensuing response also resulted in an economic shock.
Another factor that can lead to a recession is excessive debt. The Great Recession was caused by the housing bubble fueled by debt.
Both too much inflation and deflation can lead to a recession. Inflation is the steady increase in prices overtime, and deflation is the steady decrease in prices overtime. Central banks impact inflation by manipulating interest rates, and higher interest rates depress an economy. The Federal Reserve put the US economy into a recession in the 1970’s by increasing interest rates in a response to inflation. The Federal Reserve is currently attempting to control inflation by increasing interest rates. According to Neal Bawa, out of the last nine times since 1961 the Federal Reserve increased interest rates to control inflation, eight of those times they sparked a recession.
What are some signs of a recession?
According to economists, a steady rise in job losses and an increase in unemployment is an indicator of a recession. Historically, when the unemployment rate increased by .3% over the previous three months on average, a recession was usually not far behind.
Periods of high inflation are also often precursors to a recession. The higher prices go up, the less purchasing power consumers have. The less purchases that occur in an economy, the more likely it is to fall into a recession.
A yield curve is a measure of bond investor’s returns with different times to maturity. When shorter duration bonds, like 2-year Treasury notes, have a higher yield than longer-duration bonds, like 10 year Treasury notes, this is an indicator that bond investors aren’t confident about the strength of the US economy.
It’s also important to keep an eye on durable goods in an economy. If consumers are optimistic about an economy’s direction, they are more likely to purchase long term goods. Businesses are also more likely to invest in durable goods. Durable goods include machines, vehicles, and technology. If consumers and businesses are pessimistic about an economy’s outlook, then they will buy less long term and durable goods.
Consumer income is also a key metric to watch during times of economic uncertainty. During times of high inflation, even if nominal wages are increasing, real wages are likely to be decreasing. Nominal wages are measured in the amount of money received. Real wages is the nominal wage a person receives adjusted for changes in purchasing power (inflation). So, real wages are adjusted for inflation. For example, let’s say John gets a 5% pay increase. In nominal wages, he is receiving 5% more money. Now, let’s say the inflation rate is 8%. Even though John is getting paid 5% more, his purchasing power has declined by 8%, so his real wages have decreased by 3%.
What can an investor do during a recession?
As an investor, timing the market is nearly impossible. That’s why it’s important to have strong investment principles, and the ability to adapt to current market conditions. It’s not realistic to become an expert in every asset class you invest in. However, it is more than possible to find experts in each space whose credibility and knowledge you can leverage to make savvy investment decisions.
When it comes to apartment syndications, it’s a good idea to look for sponsors who have invested during an economic downturn. There’s nothing like experience to add to a sponsor’s trustworthiness and credibility. When economic turbulence is looming, you’ll want someone who’s been there before to be behind the wheel.
It’s also crucial that you choose to invest in the right asset class. Some asset classes, like retail and offices, might not have as strong of a historical track record of performing well during a recession as asset classes like multifamily apartments.
Additionally, make sure you understand the investment strategy. If the property is not expected to cash flow during the hold period, and the sponsor is banking on realized appreciation upon sale, this might not be feasible if the real estate market crashes. Be aware of the investment strategy, and understand how the macroeconomic factors can impact it.
During recessions, luxury Class A residents tend to downgrade to more affordable housing options. The demand for your property class can be impacted during a recession, so it’s important to choose to invest in a property class that remains in high demand in times of economic prosperity and decline.
How does a recession impact apartments?
Most apartments perform well during a recession. However, luxury apartments tend to feel the impacts of a recession more than other apartment classes. During a recession, luxury apartment residents will oftentimes downgrade to cheaper apartments. With fewer people to rent to, the owners of these apartments will feel the impacts of this economic change more than Class B and Class C apartment investors.
During a recession, demand for Class B and C apartments increases. During a recession, mortgage lenders tend to become more strict with their financing terms. As Class A apartment residents move to Class B apartments, there is much more demand for these mid-tier apartment units. As a result, these apartment owners tend to not have as much trouble finding residents for their apartments. However, during times of high unemployment and job losses, some residents may stop paying rent. If an apartment owner has to evict a tenant, this process can be costly and time consuming. The apartment owner will not only have to pay for the legal fees, but they will also miss out on income from these units until the resident is evicted.
However, apartments tend to be the quickest real estate property type to recover during a recession. They are also the best equipped to handle the impacts of a recession. While consumer spending habits change during a recession, which negatively impacts retail, and some businesses may downsize their office spaces, most consumers will prioritize their rent. Shelter will always be a basic human need.
Many economists and thought leaders believe we are currently in a recession. Whether or not we are in a recession, the factors that contribute to a recession are hard to ignore. Inflation is here, and GDP declined for two consecutive quarters, according to the Bureau of Economic Analysis in August 2022. That’s why every savvy apartment investor should understand what these factors are. Knowing what causes a recession can help you get ahead of the curve and position yourself in a place where you can mitigate risk while maximizing your return potential. Apartments have the historical track record that prove they are resistant to economic downturns, but it is still crucial that you make educated investment decisions when choosing which kinds of apartments to invest in and where. No one has a crystal ball, and knowing where the economy is headed next is impossible. But, empowering yourself with the right information and context can help you build wealth and protect it, even in the most uncertain of times.