Mitigating Recession Risk
In recent months, investors have become increasingly concerned about the potential for a U.S. recession. These concerns are not misplaced, as certain U.S. economic fundamentals have deteriorated, and negative GDP growth has occurred in Europe and Japan. Growth concerns are reinforced by market-based signals such as the inversion of yield curves.
Real estate values fluctuate over time, sometimes driven by local factors. However, real estate values can also fluctuate due to changes in the business cycle, as was observed during the Great Recession of 2007-2009. This thought leadership article focuses on the relationship between real estate values and the business cycle, which is composed of relatively long periods of expansion and relatively shorter periods of contraction. Specifically, this report will examine:
How capitalization rates change during recessions
Key factors of consideration in investing in MFP to mitigate recession impacts, and
Fundamental recessionary effects on MFP valuations.
COMMERCIAL PROPERTY CAPITALIZATION RATES DURING RECESSIONS
MFP investments are one of four main sectors within commercial real estate (CRE). The other three are industrial, office, and retail properties. The initial cash flow yield at which CRE is purchased is known as the capitalization rate, or cap rate for short. Cap rates vary over time, but since 1990, cap rates have stayed significantly above the U.S. 10-year Treasury yield, as shown in the chart.
The current cap rate spread over Treasuries is relatively wide, and was only wider in 2012, which marked the bottom in U.S. real estate prices. For non-U.S. investors, U.S. cap rates are even wider compared to negative bond yields prevalent in Europe and Japan. The chart also shows the relationship between cap rates and recessions. During the 2001 recession, cap rates and treasury yields fell. However, during the 2008 recession, which was caused/influenced by real estate speculation, cap rates rose while Treasury yields fell.
Historically, MFP cap rates are slightly lower than for other CRE sectors, primarily because cash flows derived from housing are believed to be more stable than cash flows other types of property (e.g., hotels, warehouses, offices, shopping malls.
HOW DO INVESTORS INVEST IN MULTI-FAMILY PROPERTIES DURING A DOWN CYCLE?
We interviewed HP Ventures, a real estate asset management firm specializing in MFP development in Chicago, where they highlight the impact of a recession on MFP valuations and how investors should think about mitigating recession risk when investing in MFP.
Economists have a poor record when it comes to predicting the timing or depth of a recession, as former U.S. Treasury Secretary stated in a December 2015 speech, when he correctly observed that “since World War II, no postwar recession has been predicted a year in advance by the Fed, the White House or the consensus forecast.” However, investors can and do take precautionary actions if they believe recession risks are elevated. They tend to rotate into “defensive” investments and away from investments with high exposure to business cycle fluctuations. The same strategy can be applied to MFP investments, which helps mitigate exposure to recession risk.
The key ideas in the following sections are:
MFP cash flows are more resilient when
Renting to tenants whose employment is resilient to recessions
Renting to tenants who have a high ratio of income to rent
Renting in locations with a high concentration of higher-skilled workers
MFP valuations were more resilient in the aftermath of the Great Recession than other CRE sectors
MFP valuations are positively affected by secular change in preference for renting compared to homeownership
FUNDAMENTAL RECESSIONARY EFFECTS ON MULTI-FAMILY PROPERTIES
RECESSIONS AFFECT MFP VALUES IN TWO WAYS
Potential decline in cash flows (e.g., tenant income levels fall, vacancy rates rise, and rent growth falls)
Potential decline in investment demand for assets (e.g., mark-to-market price declines)
RISK OF ACTUAL CASH FLOWS NOT MEETING PROJECTED CASH FLOWS
During recessions, by definition, the unemployment rate rises sharply. For example, the unemployment rate rose from 4.4% to 10.0% between 2007 and 2009. Rising unemployment causes downside risk for MFP investors; tenant income levels fall, driving vacancy rates higher than expected and rent growth lower than expected.
The chart shows the relationship between vacancies and rent growth over time.
The data clearly show that a large rise in vacancies is associated with a large decline in rental income growth, which occurred during and in the aftermath of the 2001 and 2007-09 recessions. Rent growth also dipped during the recession in the early 1990s.
Downside risk is the risk that an asset’s value is impaired, especially if the impairment is permanent. For MFP investors, downside risk rises during recessions because unemployment rises, reducing the actual cash flows compared to previously estimated cash flows.
However, rising unemployment during recessions does not hit all types of tenants with equal force. Consider the quote below, from the author of a research paper studying the effect of the Great Recession on the work force:
“We all know that employment fell dramatically during the Great Recession. It was also slow to come back up following the recession, during the recovery. This, of course, is a well-known fact. What is perhaps less well understood is why the jobs that did return were primarily the higher-skill jobs, or higher-skill ‘cognitive’ jobs — meaning jobs that require a fairly high level of education and working with information technology or working creatively, and so on. It did not really help lower-skill, so-called ‘routine’ jobs — jobs on the factory assembly line, for example — recover as much.” -Nikolai Roussanov, Wharton School of Finance, “Short-Run Pain, Long-Run Gain? Recessions and Technological Transformation,” March 2018
Summarizing the quote above, during the Great Recession, higher-skilled jobs were more resilient to recession risk than were lower-skilled jobs. It is not known whether the next recession will produce the exact same effect on the labour force.
But if the effect is similar, downside risks would be higher for:
MFP rented to lower-skilled workers compared to higher-skilled workers
MFP in locations with a high concentration of lower-skilled workers compared to higher-skilled workers
Alternatively, MFP investors might reduce downside risk to cash flows by renting apartment units to higher-skilled tenants in locations with a high concentration of higher-skilled workers. The charts below show rent growth in the U.S. (left, orange line) and Chicago (right, orange line).
Rent growth has averaged roughly 3% since 2002, both nationwide and in Chicago. However, Chicago’s rent growth is less volatile than nationwide rent growth and did not decline as dramatically during the Great Recession. While many factors are responsible for the rent growth disparities, Chicago possesses a high concentration of higher-skilled workers, which was at least partially responsible for softening the impact of the recession on rent growth.
Intuitively and empirically, higher-skilled workers earn more than lower-skilled workers. Downside risk from recession might also be reduced by attracting tenants whose ratio of income to rent is substantially higher than underwriting minimums (3:1), because these tenants likely have the financial resources, and/or a second income in the household, to remain in their apartments during a period of unemployment for one of the workers in the household.
INVESTMENT DEMAND FOR ASSETS
Recessions also have a separate effect on the investment supply/demand for assets, which become reflected in transaction prices. Some investors consider this “mark-to-market” risk to be a component of downside risk.
The chart below shows the price volatility of asset values for the four main commercial real estate classes. MFP was the least volatile sector during the Great Recession period, experiencing only 5 quarters of price deflation (in blue), compared to 13, 9, and 21 quarters for the other sectors. The MFP sector returned to peak valuations 12 quarters after the 2008 peak, compared to 34 and 33 quarters for industrial and office properties. Retail properties still have not regained their peak values.
Theoretically, the value of MFP equals the estimated net cash flow, discounted at an interest rate. Holding interest rates constant, lower cash flow volatility should result in lower asset price volatility. Throughout the Great Recession and its aftermath, MFP values were less volatile than other commercial real estate sectors, possibly because MFP rent growth was relatively stable compared to the other sectors. During periods of declining prices, other opportunities may arise. Well-capitalized MFP operators/investors may take advantage of temporary price impairment by acquiring at discounted prices.
Pricing differentials also exist within the MFP sector. The real (inflation-adjusted) price of mid-/high-rise MFP (higher-income tenants and higher density; purple line) is shown in the chart. MFP prices fell during and after the Great Recession, but asset prices were impaired temporarily, not permanently. Prices subsequently recovered and are much higher than the previous peak; doubling since the trough.
The real price of garden MFP (lower-income tenants and lower density; light blue line) fell further during the Great Recession and has not appreciated as much. However, the fact that both types of MFP have produced appreciation on an inflation-adjusted basis is evidence of their appeal as inflation hedges.
In contrast, single-family homes (gold line) have been a poor inflation hedge, which illuminates the secular rise in the demand for renting compared to home-ownership.
The Great Recession had a larger impact on lower-skilled workers than on higher-skilled workers, per the Wharton study cited in this document. More generally, recessions increase downside risk for MFP investors, because vacancy rates rise and rent growth declines. Therefore, cash flow declines, which impairs MFP values (interest rates held constant). It is unknown whether the next recession will have a similar impact, but if so, it may be possible to reduce downside risk by renting to tenants:
Whose employment is resilient to recessions
Who have a high ratio of income to rent
In locations with a high concentration of higher-skilled workers
Some investors also pay attention to downside risk created by “mark-to-market” losses, which occur due to imbalances in the investment supply/demand for MFP during recessions, when marginal operators experience financial distress. During these periods, well-capitalized and efficient MFP operators may take advantage of temporary price impairments to generate above-average prospective returns.
From a longer-term perspective, today’s cap rates are high relative to U.S. Treasury yields, which provides a margin of safety. MFP asset values have risen over the past two decades on an inflation-adjusted basis, a period that included the Great Recession. However, prices have appreciated more for MFP focused on higher-income tenants than for lower-income tenants.
Special Thanks to Our Contributor
HP Ventures Group LLC - Development Services is a real estate asset management firm, focusing on multi-family properties in the Chicago region. HP manages all facets of a property’s life cycle, from acquisition, through development, to property management. Our properties include high-end residential and mixed-use buildings.
5000 West Lawrence Avenue
Chicago, Illinois 60630
Peter Cook, Partner
Director of Capital Markets