As real estate investors, we begin the new year with just a bit of trepidation. Many economists are predicting a recession in 2020, but in some asset classes, the slowdown has already begun – and some real estate pros are responding.
Conference on Capital Markets
The Schack Institute of Real Estate held its 51st Annual Conference on Capital Markets at the end of November in New York City. The agenda touched on many topics, including what investors and lenders are doing to address the risk of recession. We’re not seeing obvious signs of recession yet, but they say they want to be prepared.
John Jacobsson of Related Companies was one of the speakers. He said, in an Urbanland blog, “I know in my heart that there will be a correction, though I can’t tell where it’s going to come.” (1) They are faced with investment yields that are growing smaller and the risk of investing at the end of a very long economic expansion. If it continues into June of 2019, it will set a new record. But it could reverse itself soon, and push the nation into recession. A recession is officially defined as two quarters of negative economic growth. Our current GDP is 3.4%.
Increasing Cash Reserves
The Carnegie Foundation’s investment director, Alisa Mall said at the conference, “We are positioning as if there is going to be a recession.” She says they are rebalancing their investments by trimming real estate and increasing cash. She says, “We want to have dry powder.” (2)
Lower Yields vs. Slower Timelines
Fund managers are also lowering their expectations. They say they have to work harder to find solid deals — sometimes they accept a lower yield and sometimes they spend more time finding a deal with a higher return. William Rahm of Centerbridge Partners says it’s a trade-off — either you “toggle pace or toggle return.”
Buying Niche Properties
When they do buy properties, they look for more recession-proof investments, like student and/or senior housing. Mall says those kinds of properties will still produce income during a recession. Other so-called niche investments include things like data centers and cellphone towers. Gary Phillips of Allianz Real Estate of America finds it odd they are considered “niche” because “everyone keeps talking about them.”
Appreciation, Rent Growth Dilemma
Investors are also faced with slower price growth. Although property prices are still rising in many places across the country, some markets have stalled or even slightly reversed, and economists expect that to continue in 2019. Rents are also very high, and have grown faster than wages, making it difficult to keep raising rents. Khaled Kudsi of Northwood Investors says they are “now 20 percent to 30 percent above prior peaks.” It’s a two-faced dilemma for investors when it comes to choosing appreciation or rent growth, because both are retreating. (3)
It’s also costing more for leverage because of rising interest rates. The Federal Reserve just raised short-term rates for the ninth time since 2015. The Board increased its benchmark rate by another quarter point, to a range of 2.25% to 2.5%. Economists expect several more rate hikes next year, especially if the Fed see signs of inflation. Urbanland says that this environment is putting pressure on all types of real estate investors.
Long-term interest rates have also risen, but not as much. Urbanland says that lenders have cut into their own profits to keep their rates lower. But the blog says they cannot keep cutting into the spreads they offer to borrowers. Related Companies’ John Jacobsson says, “Spreads can’t go to zero.”
Lenders Compete for Deals
Lenders are competing for a smaller pool of borrowers than they were a few years ago. Plus, they are competing against a growing private lending segment, where investors pool their money to pay for a project.
But according to David Lehman of Goldman, Sachs, they haven’t reduced equity requirements for borrowers. He told Urbanland that borrowers are still required to have a 50% equity stake in conduit loans, compared to just 30% during the last boom cycle.
Higher borrowing costs are expected to reduce the size of future loans because of lender income requirements. They typically want an income producing property to generate 1.25% of the monthly payment. If rent levels are constrained, and interest rates are rising, then the principal will have to be reduced.
Urbanland says the need for non-bank lenders may grow, as regulations keep many large banks from meeting the needs of investors. Some companies are also creating their own lending arms to help finance construction projects. That’s what we do at Real Wealth Network.
The bottomline is – the next 10 years will not likely be like the last 10 years. That means your strategy needs to change along with the changing times.