Updated: Aug 16, 2022
Many investors overlook the importance of economics in their personal investment portfolio. As an investor, it’s critical that you have a firm understanding of how the economy impacts the asset classes you place your capital in. Every economic cycle consists of booms and busts. But, even the smartest economists can’t predict with exact precision when the next recession will occur. That is why it’s important for an investor to build a portfolio of investments that are recession resistant.
For many investors, protecting their investments is more important than making a return on their capital. It’s not uncommon to hear someone say that all investing involves risk. But, there are ways to mitigate risk when investing in real estate. A key way to do this is to be aware of what is going on in the economy.
Within real estate, the risk varies depending on which property type an investor chooses and where the property is located. Multifamily real estate as an asset class has proven to be historically recession resilient, and when compared to other property types and asset classes, it has outperformed them during previous recessions. Although changing economic times might have an impact on the profitability of apartment investing, the demand for housing will maintain the strength and reliability of this asset class.
Multifamily real estate is recession resistant because of the strong demand for it, its flexibility, and its ability to act as a hedge against inflation.
Demand for Apartments
The demand for apartments is self-evident. Shelter is among one of the core needs of human beings, along with water and food. If people do not own their own home, then they will rent a place to live. This is seen in the recent increase in demand for housing in the United States in recent years.
Multifamily arguably remains in demand during any stage of the economic cycle. According to National Multifamily Housing Council studies, the US needs an “average of 328,000" apartment units a year in order to keep up with demand. But we’ve only been able to meet that need twice since 1989.
Increased levels of immigration and population trends have also increased the demand for apartments. This reinforces the argument that apartments will remain in high demand in the event of a market downturn. During a recession, people are more likely to save money and cut spending. This has a negative impact on retail, hospitality, and office spaces. But, people will still need a place to live.
Housing is Essential
When times are hard, financial priorities might shift among struggling consumers. Rent is typically high on their list. During times of economic hardship, people tend to prioritize rent (their shelter) over car payments, and credit card payments, for example. If they don’t pay their rent, however, they’ll be evicted and end up homeless. As you can imagine, most people want to avoid that at all costs.
Resilient Property Class
For an apartment to lose residents and not produce income, there would need to be an excess supply of apartment units and a resulting decline in rents caused by competition between apartment owners. During a recession, demand for apartment units increases. With the existing shortage of apartments, it is highly unlikely that an apartment would lose residents and not produce income. This is especially true if the apartment is located in a strong market where demand is high. This includes places like Atlanta, Georgia, Florida, and the Carolinas. Real estate is often considered to be locally based. So, while New York City might be experiencing economic hardship, the Charlotte, NC real estate market might be booming. That’s why it’s important to understand the local market where you’re investing, and to have a firm grasp of the economic factors at play there. These include major employment industries, population trends, major economic anchors, and more. Besides the local market metrics, multifamily is likely to remain in high demand in the foreseeable future.
Flexibility of Apartments
In fact, many people prefer to rent an apartment over owning their own home, especially during a recession. According to an article in The Zebra, 77% of Americans prefer to rent then purchase a home. The short-term nature of apartment leases allows people to remain flexible during a recession, so they can easily adapt to changing economic conditions. With a home, residents may feel anchored down, and might be forced to pay for costly expenses during times when they are struggling financially. During recessions, people typically downgrade from luxury apartments to more modest ones, and downsize from homes to apartments. This explains why Class B apartments remain strong at any stage of the market cycle.
Challenges of Buying a Home
For those Americans that want to purchase a home, it might not be a feasible option. Mortgage lending terms tend to become stricter during a recession. So, for those who do want to purchase a home, the reality of doing so becomes more difficult to obtain. It is harder for them to qualify for a loan, and they are left with no alternatives but to rent until the debt market softens. The less financing options available, the larger the renter pool becomes.
Lack of Housing
In the United States, the construction of housing is not keeping up with demand. The cost of construction and a shortage of labor are two main factors keeping new construction below where it needs to be. This lack of housing increases the pressure on the existing supply. Home prices and rental rates in desirable markets have been increasing in recent years, with some cities experiencing 40% increases in rental rates as housing competition ramps up, as mentioned in an article in The Guardian.
It’s also important to note that during times of rising inflation, property values tend to increase as well. Therefore, apartment properties act as a great hedge against inflation. As mentioned by Rent.com, rental rates for a one-bedroom apartment in the US have increased an average of 26.5%, while two bedroom rents have increased by 25.7%. This is higher than the reported inflation rate of 8.5% as of July 2022. Not only can investors still make a strong return on their investment during inflationary recessions, but they can also preserve their purchasing power through multifamily investments.
Historical Track Record
Let’s take a look at the historical performance of multifamily during recessions. During the 2007-2009 Great Recession, unemployment rates in the US hit up to 10% nationwide (Merlynn Acquisitions). Multifamily real estate performed well compared to other asset classes during this time. The Urban Institute reports show that from 2007 to 2018, multifamily delinquency rates peaked at only 0.5 during this time period. Delinquency rates in real estate refer to the amount of debt taken out to purchase real estate that is past due. They quickly declined after this peak in the following years. Even during one of the worst economic recessions in US history, multifamily real estate experienced low default rates on debt.
The Sharpe Ratio is a useful metric that compares risk-adjusted returns between different asset classes, according to Merlynn Acquisitions. A recent NMHC study demonstrates that multifamily consistently outperforms other asset classes over hold periods between 3-15 years on a risk-adjusted return basis. Apartments had a stronger Sharpe ratio than other asset classes.
As seen in the graph below from Arbor Crowd, during the five years after the Great Recession, apartment REITs outperformed other commercial real estate asset classes and the S&P 500.
During the past five recessions the US has faced over the last four decades, multifamily has outperformed every other real estate asset class. Even during the Great Recession, the US rental vacancy rate only peaked at 10.6% in 2009 before falling according to The US Census Bureau.
Caveats of Multifamily Investing
While multifamily has proven to be a strong performer during economic downturns, there are some things to keep in mind.
When an economy is experiencing stagnant growth and rising inflation, the consequences are known as stagflation. The Federal Reserve, in an attempt to deal with rising prices, will increase interest rates (as we have seen in recent months). The increase in the cost of borrowing money should slow down economic growth, which should result in slowing down inflation. Increasing interest rates also increases the cost of debt in the multifamily industry. This makes it much more challenging to find a profitable deal, and if apartment investors have to refinance during a time when interest rates are high, they might be stuck in a difficult position.
In a recession where prices are rising, the cost of building and construction are also likely to increase. Investors budget a certain amount of money in order to implement their business plans, especially distressed property and value-added investors. This makes it generally more expensive to fund multifamily projects, and requires investors to bring more upfront capital to the deal. This can eat into returns, and make the deal less profitable overall.
Multifamily real estate is an asset class that has stood the test of time. During the past five recessions, it has been the top performing real estate property type. The need for it is a clear indicator of why it has the ability to weather economic turbulence. Even in times when rental rates declined, it recovered quickly and with more resiliency than other asset classes.
While the strength of a multifamily property is contingent on its specific location and the business plan associated with it, the industry overall has performed at every stage of the market cycle. Multifamily real estate, unlike offices and retail, isn’t considered a discretionary expense by consumers.
People will always need a place to live, and as long as they do, apartments will provide housing for those who don’t want to buy or cannot afford a permanent residence to own. Investing with a recession-resistant lens will allow you to build wealth and protect it for generations to come. Multifamily real estate has proven time and time again that it will continue to be a sound investment for investors hoping to preserve their wealth in times of economic hardship.