Let’s address the elephant in the room. Recessions aren’t very much fun. But here we are looking over the edge, and it could be a few months more before we see the bottom. (This writer was horrified to realize he was excited to pay $4.81 for gas a couple weeks ago.)

But for seasoned investors with long time horizons, surviving recessions is just part of the job. In some cases, getting to the other side without losing your shirt might be reason enough to celebrate. But in a lot more cases, bear markets can actually be powerful opportunities. That’s doubly true for investors whose portfolios include lots of resilient assets with predictable demand structures.

As it turns out, real estate investors can do a lot to minimize bear markets’ impact on their portfolios, and come out on the other side raring to go instead of licking their wounds. It’s all about strategy. And today, we’re gonna talk about it.

What’s going on?

This seems like a good place to start. Like we’ve said before, every single asset class experiences price fluctuations. Some are more volatile than others. Some correlate more or less to what’s happening throughout the market as a whole.

And, explaining what causes recessions goes well beyond the scope of this article. But recessions do have a few (fairly) predictable impacts on the real estate market, so let’s start there.

• Supply exceeds demand. Rising costs, employment insecurity, and myriad other forces make people hang onto their money during recessions. The same is true for investors. So, demand for real estate falls (although not equally among all product types), and properties remain on the market for longer.
• Prices fall. Sellers won’t give up quite so easily. So, they’ll tempt buyers to bite with lower prices. But buyers still might not be able to get enough cash together (especially when you consider point #4, below). What’s more, sellers are only willing to go so low; for those who can withstand a temporary loss, it might be better to hang on than sell for a deflated price.
• Money costs more. Recession usually comes with inflation. (Which is the cause and which is the effect is controversial, but the correlation is not.) That means the Federal Reserve is likely to want to contract the money supply. Although its full process is pretty complicated, the Tl;Dr is that interest rates will rise and borrowing will become less attractive. For investors looking to finance new projects, this can be problematic.
• Revenues fall. Depending on how bad the recession gets, rental property owners might start losing income as tenants either fall behind on payments or seek more affordable accommodations elsewhere.

How to Fight the Bear

(We’re gonna be perfectly honest: we tried to find a good bear gif, but none of them worked out. We apologize for being the bearers of bad news. We’re not sorry, however, for the unbearable pun. See? You’re laughing now. Or you wanna hunt us down. Could go either way.)

We’ll start by noting: investors with different strategies may or may not be positioned to implement what we’re about to say. One size most definitely does not fit all. That said, planning for a recession is the kind of thing that usually only works if it happens, well, before the recession. Picking an investment strategy involves numerous considerations, but surviving inevitable hard times has to be one of them. And, although real estate is generally a fairly resilient asset class, there are still higher- and lower-risk options in the real estate space.

We design projects with an eye towards what will happen to our investments when the economy takes a body blow. Here are a few strategies that have worked well for us:

1. Protect Demand

One of the best things about real estate is that it’s an avenue to passive income. Many investment options — like commodities, crypto, or non-dividend stocks — only make you money when you sell them for more than you originally paid. Real estate is different. Rental properties augment the typical appreciation avenue with operating income: rents-minus-expenses checks in the mail that, depending on your position, either fuel stakeholder distributions or line your pockets.

The problem is that this strategy makes rental owners reliant on overall market conditions. If your tenants can’t pay, or don’t want to pay, or would rather pay less with the landlord down the road, your income stream dwindles and you might not be able to pay your mortgage. Which is, y’know, bad news.

But not all real estate is created equal. Some investments benefit from more resilient demand than others. One of the reasons we like investing in housing is that housing demand is comparatively very resilient. After all, everyone needs a place to live. That’s true even when the market takes a dive. Because housing is a high priority, people are likely to make cutbacks in other parts of the budget before downgrading their housing situation.

When housing does get too expensive, tenants could abandon luxury condos pretty quickly. Class-A apartments in trendy hipster neighborhoods might command lofty rents when times are good, but they just can’t keep up with high-quality, affordable workforce housing when the market sours. Case in point: during the peak of the Covid-19 pandemic, the market took an absolute beating, but demand for affordable housing stayed strong.

Part of the reason for that is basic economics. Take a good with relatively inelastic demand, and offer a competitively-priced version of it. People will buy it during good times, and keep buying it during bad times. People don’t stop buying milk and eggs just because the economy’s struggling. It also helps that keeping the housing market afloat is an important policy priority, which means the government is simply more likely to bail out workforce housing than most other sectors.

Shiny, luxurious hotels and condos might look like great investments when business is booming. But when the market goes south, we’ll take our workforce housing any day, because protecting demand keeps the business model online.

2. Be Countercyclical

It’s one thing to survive a recession. It’s another thing to thrive during one.

Countercyclical assets — those which increase in value when the market decreases in value — belong in everyone’s portfolio. Some people buy gold, others buy crypto. (Although crypto is apparently not as recession-proof as some people thought. Stay tuned for our thoughts on that little debacle.)

Real estate is countercyclical in general because it’s a reliable store of value. Everybody needs land, so it can function as a safe haven during recessions. Once liquidity increases on the tail end, it’s one of the places demand will naturally land.

But some real estate investments can benefit from heightened demand during downturns. The fleeing luxury apartment-dwellers we mentioned earlier, after all, need somewhere to go when they can no longer afford their digs. More generally, when prices get too high at the top, consumers look for ways to cut costs. 

Middle-of-the-road housing satisfies that need — a need which is most likely to arise during recessions. Unless a recession gets bad enough that people are willing to abandon housing altogether (in which case investors probably have worse problems than dwindling revenues), affordable housing is likely to gain demand during downturns.

3. Use the Cycle

Recessions are a bad time to sell property. Appreciation is likely to slow or reverse course, and holding on is often better than cashing out for reduced prices.

But it might be a great time to buy property. (With a caveat we’ll explore in a sec.) When the housing bubble burst in 2008, and prices fell to historic lows, some investors flocked to buy devalued assets. Those with the liquidity to buy, and the reserves to withstand a couple low-income years, found themselves holding high-value properties they acquired for a fraction of their usual value. Timing the market can be dangerous business (and would-be buyers should watch out for overleveraging their acquisitions, especially when rates are unusually high), but it can also be lucrative. Just don’t go overboard on leveraging high-risk deals.

Moreover, rising interest rates might prove a double-edged sword. True, higher rates make it harder to lever up. However, over the long run, interest rates correlate with cap rates. If cap rate compression is a seller’s boon, cap rate inflation is a buyer’s. If the rate market signals that utilization is low, then asset prices will eventually fall proportionally. Whether that offsets increasing capital costs is anyone’s guess, but investors looking to capitalize on decreased demand to make tactical acquisitions might find that correlation useful.

4. Keep a Lid on Risk

Sometimes you get a bad break. Depending on how tight a recession gets, investors might not be able to realize too many of their strategic benefits. When that happens, the key is not coming out the other side shirtless.

If the economy really takes a beating, the investors who do that will be those who prepared to weather fallow periods. Doing that is pretty conceptually simple: diversify holdings between classes and geographies, offload underperforming assets, watch out for capex-heavy money pits, ensure your illiquidity tolerance is at reasonable levels, etc.

And, if you’re a private individual or family office, make sure you aren’t too concentrated in one kind of investment. Might sound strange to hear us say it, but a well-balanced portfolio needs more than just real estate. And, mainstreet investors should probably stay away from high-value make-or-break assets and consider options like REITs that offer diversification even on a relatively modest principal.

Concluding thought: when is it time to buy?

Tl;Dr—recessions happen. If you’re staying in the game long enough to make serious money, you’re going to face more than one. In one sense, that’s a great reason not to panic. Every recession that’s ever happened has come to an end. But that fact raises a question we’ve looked at before: When is it time to move money off the bench and back into the game? 

The answer to that question is complicated (for a longer discussion, click this shiny blue hyperlink), but we stand by what we’ve said before: valuations are hard now. Setting aside edge cases where fortuitous acquisitions and coincidences mint overnight millionaires, outcomes for the mine run of investors are going to come down to who correctly forecasts the right valuation paradigm on the back end.

Put differently, the interaction between interest rates and cap rates is going to make or break investors’ profitability. Investors who need rent growth to stay afloat should beware volatile markets. Investors who can ride the wave of cap rate compression can rest a little easier, but because of the theoretical interaction between inflation and rising cap rates, these investors, too, should keep an eye on the horizon.

Plus, there’s a deeper question lurking on the margins of this whole discussion. We’ve said it before, and we’re saying it again now: cap rate as an NOI multiplier might not be a great proxy for valuations in uncertain environments where cash flows could fluctuate wildly. Buying lower-risk assets helps a lot here — that’s why we like workforce housing. And, our investment thesis got its trial-by-fire during the Covid-19 pandemic: a once-in-a-generation black swan event that put virtually everybody on the back foot. Fortunately, the coming recession just isn’t that kind of cycle-busting anomaly. If the market gets back to business as usual, then traditional valuation paradigms might serve would-be buyers just fine. But if it doesn’t . . .

We’ll reward you for making it through this long-read by putting our cards on the table. We believe that slow and steady wins the race. Deploying capital into slower-growth environments has one disadvantage: you don’t get rich quick. But we think long-horizon investors will ultimately perform better by buying assets that preserve cash flows when the economy hurts. Those assets won’t appreciate as quickly as their Class-A counterparts, but they will protect revenues throughout the business cycle. And if investors can stay cash-flow positive throughout their portfolios, then a few slow months won’t bust the fund.

Thanks for reading.