“Time in the Market is more important than timing the market.” — Charlie Munger
You may have seen the headlines: We are heading into a recession.
We may actually already be in a recession right now.
The yield curve has inverted.
This means two-year and ten-year treasuries have flipped.
Typically two-year treasuries offer a lower annual rate than the ten-year treasuries.
But now it’s the opposite.
When these treasuries flip there will be a recession typically within 12 to 18 months.
These trends are something we watch very closely.
As we head towards a recession, the question becomes: What is a recession proof investment?
How should you align your investments?
Inflation is high.
Asset prices are high.
What should you do with what you have?
Let’s break it down in three simple steps.
1. We Are Heading into a Recession
Interest rates are continually rising.
The Federal Reserve in the past has bought assets at $120 billion per month.
Some of that money is mortgage back securities, which has kept single family interest rates low.
They’ve also been buying treasuries.
Now they have raised interest rates by a hefty 0.75%.
They’re trying to calm inflation.
They made money cheap by buying all these assets and keeping interest rates low.
It’s caused the value of everything to go up.
You can see on this chart that the M2 money supply as well as physical currency has spiked 40.9%.
From February 2020 to February 2022 there has been a 40.9% increase in the money supply!
We’ve never had a time in U.S. history like this.
This means inflation is here to stay.
It will be very difficult and painful for them to actually break the back of inflation.
We saw this in the 70s when Paul Volcker, the head of the Federal Reserve at the time, brought interest rates to nearly 20%.
Think about that for a minute.
You think a 5.5% interest rate for real estate is high?
I don’t know if official inflation numbers will reach 20% but it will be painful as rates rise.
We’re headed for a time of stagflation.
That means the economy will get worse as inflation remains high.
We’re headed into a recession.
Unemployment is high.
Inflation continues to rise.
Everything is getting more expensive.
What about the stock market?
What about investments?
What should you do?
This is where things are gonna get fun!
So buckle up and let’s jump into it.
2. How is Single Family Affected?
How will your house or rental homes be affected?
In December of 2021, the single family mortgage rate on average was 2.9% for 30-year fixed debt.
That’s really low!
In May 2022 the rate was 5.3%.
That’s almost double in five months!
As an example, let’s take a $500,000 house payment.
If you have a 2.9% rate, then the payment would be $3,094 per month.
If you have a 5.3%, it’s now $3,790 a month.
That is a 22% increase in the total payment.
We then get to the idea of what is affordable.
A lot of people are not able to afford housing at the current prices.
It’s not just the price of a house but the increased interest cost as rates rise.
What does this really mean for single family housing?
For the long term, we know there will be a lot more money printing.
The money supply has increased by 40.9% in a couple years and it will continue to do so.
We know in 30 years the value will be significantly higher because they’re printing more money.
The single family housing prices could drop by 30 to 40%, but that could maybe take three to five years.
If you look at the Great Recession, single family house prices started to decline, but they didn’t reach their lows until Q1 of 2012.
That’s five whole years later.
Some single family housing prices actually started declining before 2007.
In Los Angeles area we saw a five-year decline before things started coming back up.
Now, I could be wrong on all of this.
When rates rise in the short term, affordability goes down.
If you have 30-year fixed debt, you don’t have to sell.
You can ride that out for the long term and be just fine.
So these houses will perform just fine over the long term.
In the short term, you have to weather the recession and make sure you have long-term fixed debt.
This becomes a way to short the dollar.
If you have 30-year fixed debt, the asset is not necessarily the house.
It’s the loan.
I have friends who have a 30-year fixed debt of 2.5%.
That’s pretty amazing!
Inflation will continue to grow substantially higher.
The value of their home will be worth way more in the future.
Now that we’ve talked about single family, let’s talk about multifamily and its benefits.
3. How is Multifamily Affected?
With all of this going on, a lot of people are wondering about the real estate market.
Well, there’s no one real estate market.
There’s single family and multifamily.
There’s city and suburbs.
There’s commercial and industrial.
The real estate market can be very different from one asset to another.
Single family and multifamily can be night and day when you compare them.
A lot of people are shocked to find this out, but it’s really true!
Let’s look for a minute at how single family performed in a recession versus multi-family.
You can see on this chart that in 2009, the worst point of the Great Recession, single family had a 4% default rate.
That means 1 in 25 homes were in default or delinquency.
At the same time, that line at the bottom shows multifamily at 0.4%.
That’s 10x less!
If people lose their houses, where do they go?
They go to multifamily.
They go to working class housing, which is what we do.
We do B- and C-class apartments.
We love, love, love multifamily – particularly in a recession.
People need somewhere to live.
Multifamily is much more stable.
Even at the time of this blog, the interest rates for multifamily loans are rising.
They’re not rising as fast as single family, but we are seeing a rise.
One thing we do to limit our potential liability of higher rates is shorter term lending.
This is also called bridge debt.
We typically do bridge debt for three years and get a couple of one-year extensions.
We pay for insurance with a capped rate.
This rate won’t go above a certain point.
Insurance is getting more expensive, but we won’t pay over a certain amount.
So what happens to the value of multifamily during a recession?
When cap rates are high, you have to pay less money to get more income.
Right now, cap rates are low.
That means valuation is very high.
In general, you would think cap rates will rise.
That probably will happen over time because interest rates are rising.
However, there’s a big ‘but’ attached to that.
Multifamily is different from single family in that single family is based on sales comparables.
The value of a house is based on the house that sold across the street last month.
Multifamily is not like that.
Its value is based on how much income comes from the property.
Earlier, we talked about the money supply continuing to grow.
As inflation continues, rents will generally keep pace.
You can see on this chart how those two go hand-in-hand.
As inflation rises, rents will continue rising to keep pace.
That will cause the value of these properties to go up.
If the rates keep going up, the valuations may come down, but I still think it will balance out.
We’re also short today around 6.8 million needed housing units. Some would say the number is lower, but we haven’t built enough apartments over the past 15 years.
They can’t build them fast enough.
It’s hard to build anything these days because everything costs more and more.
The fact that we have these apartments and can renovate them can be really valuable.
One example of this is in Jacksonville, Florida.
When we bought a property there last fall, the average rents were $900.
We’re seeing renovated units go on average for $1,425 right now.
That’s a huge upside!
We’re buying in markets where we’re seeing these prices.
Over time, we will see that multifamily is very different from single family.
It’s also different from investing in REITs or other types of crowdfunding.
We have a value-add approach in multifamily where we do renovations on individual units.
This gives a certain margin of safety.
This is especially useful during a recession.
If people move down from Class A apartments to Class B or C apartments, those rents may actually go down.
There’s no real way they can increase the value just by doing renovations
When you buy these apartments when their rents are already low, you have a better chance of success.
We can do forced appreciation to increase the value.
If you have a fixed rate or single family, consider keeping it with the knowledge that the value could dip in the next three to five years.
Then consider getting into multifamily versus cash just sitting in a bank.
You could be losing 8.5% to 20% per year, depending on inflation numbers.
Now I want to hear from you!
How are you preparing for recession?
Stick your answers down below.
Before you leave, make sure to check out our special report about investing. It compares the stock market to real estate, and it also includes how the pandemic affects your investment future.
If you are interested in investing with us, we are happy to answer any questions that you may have. Join our investment club today and we will be in touch.
Disclaimer: I am not your investment advisor. This is for educational purposes only. I am not giving specific advice on what you can do. I am simply giving my opinions.