What Does the Inverted Yield Curve Mean for Real Estate Investors?

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An inverted yield curve has become a sort of meme for an impending recession of doom—even though most people have no idea what it actually means.

In August, the yield curve inverted with the yield on short-term bonds surpassing the yield on long-term bonds, which is the opposite of normal conditions. For many months, the two rates had been very close, or “flat” as it’s described. As of today, the spread on the 1Y-10Y (one-year to 10-year) bonds is negative 0.05 percent (i.e., inverted).

What Does an Inverted Yield Curve Mean?

So, what does it mean for a yield curve to invert, and why does it happen? I will let BiggerPockets’ own J. Scott explain it,

“As investors grow wary about the economy, they start to move money out of other investments and into long-term bonds for longer-term security. They don’t want their money in real estate or the stock market, because they are concerned about where the values are heading. In contrast, government bonds seem safe and promise a fixed return.

“So, in economic periods like these, increased demand for bonds reduce the yield of long-term bonds. At the same time, the desire for long-term security prompts investors to move money out of short-term bonds. Therefore, lagging demand for short-term bonds increases the return on them.

“When short-term bond yields increase and long-term bond yields drop, the curve flattens.”

The spread on the 2Y-10Y is slightly positive (0.06 percent) as of this writing, but it briefly dipped negative in August. A 2Y-10Y inversion has preceded every single one of the last nine recessions—although by as much as 34 months. For the 2007-2008 Great Recession, the yield curve inverted 22 months prior to the bottom falling out.

Of course, while the 1Y-10Y is inverted, the 2Y-10Y was only briefly inverted—and barely so. Many economists don’t see a flat yield curve as hugely worrisome and don’t believe it necessarily spells doom.

But Harry Truman once quipped, “Give me a one-handed economist. All my economists say ‘on one hand…,’ then ‘but on the other…'”

So, I will try to be a bit bolder in my predictions.

The State of the Economy

The recently inverted yield curve is just one of many signs that the American economy is heading for a recession in the next 12 to 24 months. The first is simply the old dictum that all good things must come to an end. We are currently in the middle of the longest expansion in American history. As of September, the United States has had 123 months of uninterrupted growth (minus a bad quarter here or there). (6) The previous record was 120 between March 1991 and March 2001. Only three have lasted over 100 months and only five for over five years.

As Herbert Stein succinctly put it, “If something cannot go on forever, it will stop.”

In addition, there are some other worrying signs with regard to the American economy:

• Both the Dow Jones and the Nasdaq have been essentially flat since June.
• Median household income has been flat for several decades. Although, it is important to note that per capita income has gone up.
• Auto sales are down 2.4 percent thus far in 2019 from the previous year.
• The OECD’s Consumer Confidence Index has dipped slightly from a five-year high of 100.91 in March, 2018 to 100.08 in August of this year. Anything below 100 is considered a pessimistic outlook and the last time it dipped below 100 was right before the 2008 financial crisis.
• The University of Michigan’s consumer sentiment is also down from 100 in May of this year to 93.2 in September.

That being said, there is still a shortage of housing in many areas and according to the National Association of Realtors, home prices have increased 4.7 percent between August 2018 and August 2019, and total sales were up 2.6 percent over the same period. The rate of price increases is declining; however, and inventory is increasing.

And unfortunately, another set of statistics should cast doubt over whether that upward trend in prices and sales can continue. Those statistics address the woeful debt situation our country is in at virtually every level.

• The national debt hit a record $22 trillion in 2019.
• The national deficit hit a record $1.1 trillion in 2019.
• State governments have an additional $1.2 trillion in debt and many municipalities are also loaded with debt.
• Mortgage debt hit a record of $9.4 trillion in 2019, surpassing the previous high of $9.3 trillion in the third quarter of 2008.
• Consumer debt hit a record of $4 trillion in 2019.
• Credit card debt hit a record of $870 billion in 2019.
• Student loan debt hit a record of $1.5 trillion in 2019.
• The American savings rate has dropped from a high of 6 percent in 2015 to only about 3 percent in 2018.

And this doesn’t account for the very high levels of medical debt held by many Americans. (13)

Debt can be good, but this much debt—and particularly this much consumer debt—is a disaster waiting to happen. As a country, this mountain of debt hasn’t lead to a wave of delinquency yet, but the keyword is “yet.” Even still, the picture is mixed with the foreclosure rate improving while auto repossessions and student loan defaults have increased.

• Bankruptcies have ticked up slightly in 2019.
• A record 7 million Americans are behind at least three months on their auto loan payments.
• A record $166.4 billion in student loans is more than three months past due. (This represents 11.4 percent of all student loan debt.)
• Data is harder to find, but evictions appear to be increasing nationwide.
• Conversely, foreclosure filings have decreased 18 percent between the second quarter of 2019 and 2018.

Much of the reason this picture looks OK is that the national unemployment rate is still a very strong 3.7 percent. Although, the labor force participation rate is still quite low by historical standards. But when unemployment starts to go up even a relatively small amount, that will likely cause a good amount of delinquency on this vast sea of debt we as a country have racked up. And things could easily snowball from there into a recession.

What’s My Verdict?

First of all, let me see how many wiggle words I can put in here. My verdict is that we are, in all likelihood, probably heading for a recession in the relatively near future. I doubt it will be before the end of 2019, but I would be surprised if it didn’t begin in 2020. That being said, predicting recessions is an extremely difficult task. Many an economist has bet the farm (and by that, I mean waged absolutely nothing) by successfully predicting seven of the last two recessions.

Christopher Nolan put it well while promoting his film Interstellar, as he compared the precision with which physicists can make predictions versus the train wreck that is economics: “Take a field like economics, for example. [Unlike physics] you have real material things and it can’t predict anything. It’s always wrong.”

Hell, economists are still arguing whether or not the New Deal alleviated or prolonged the Great Depression.

Finally one last caveat, every market is local and the effects of a recession would be quite different depending on which market you are in.

With those things in mind, I still think the yield curve inverting, the record-setting length of this expansion, the sheer amount of debt Americans have, and other negative economic indicators signify a high likelihood of an impending recession. We’ll see how I did on January 1st, 2021. (And by that, I mean I’ll gloat about it as respectfully as one can during a recession if there was one, and I will attempt to bury this article if there has not been one.)

How Should Real Estate Investors Respond

First and foremost, I would recommend picking up J Scott’s book on investing in a recession. It’s always good to be prepared ahead of time, and Mr. Scott is as good as they come in this regard.

Other than that, I would make five major recommendations

1. Don’t Make Radical Changes or Simply Wait on the Sidelines

I had a friend who bought two houses after the crash in 2008 but then became convinced the market was going to go into a recession. So, he wanted to wait until afterward to buy more. This was in 2015. While he got two, he missed out on capitalizing even more on a great bull market in housing. You simply can’t know when the market will turn.

By buying right (with at least 25 percent equity or more), you will insulate yourself from almost any correction. Even a harsh correction like we saw in 2007-08 came back up to where it was before the crash in a couple of years. There’s something called “dollar-cost averaging,” where you spend the same amount of money each year even if the price goes up or down. That way, when things are overpriced, you buy less and when they are underpriced, you buy more.

This is a simplistic way of thinking of things, of course. It was coined for stock investing. With real estate investing, it’s not quite as applicable. You should never purchase bad deals even if that means not buying anything. But the concept is still helpful.

Again, you have no crystal ball. Don’t stop or radically change things because you believe a recession is coming down the pike.

On the other hand (sorry, Mr. Truman), if you don’t plan to hold your rentals for too much longer anyways, now would not be a bad time to start selling them.

2. Hold More Cash

Fortunes are made during recessions. Warren Buffett, for example, has famously made his biggest gains during and immediately after recessions. Yes, fortunes are obviously lost during recessions, too. But because assets are being sold cheap, they can also be bought up cheap.

If you have cash during a recession, there will be tons of opportunities. I remember with some nostalgia doing property tours of 12 to 15 REOs at a time back in 2012. The prices then were simply incomparable to the prices now. While the next recession probably won’t hit housing anywhere near as hard, there will still be many opportunities.

I would add that getting private lenders and/or credit lines should be sought in addition to holding more cash. We were able to buy a lot of properties around 2012, because when the banks weren’t lending, we had private lenders we could go to for funds.

Another major reason to hold cash is that not having enough cold hard cash is a good way to get yourself into trouble. Recessions hit housing prices, but they also hit rents and increase delinquency. When people lose their jobs, oftentimes they stop paying rent. Or you might get caught with a house you are flipping when the recession starts, and take a bath on it. Either way, a lack of liquidity is always what gets people in trouble in a recession.

It can be hard to hold cash as a real estate investor, especially if you are just starting out. But it’s something to put an added emphasis on as we likely near a recession in order to both increase your security and to take advantage of potential opportunities.

3. Shy Away from D Properties

I’m generally in favor of all but specialists shying away from really rough areas. That recommendation grows even stronger when a recession appears to be in view. This is because the residents of D properties are generally the first to stop paying their rent. This can throw you into a cash crisis that is the dread of every real estate investor.

4. Tighten Your Buying Criteria

I always recommend that BRRRR investors aim for a 25 percent discount. The 70 percent rule goes further and asks for a 30 percent discount. Either way, I would pad that required discount a bit. By no means should you stop buying, but you should make your criteria a bit tighter to insulate yourself more if the market does dive.

Furthermore, I would emphasize to make due diligence a priority. This should always be the case, but go ahead and double your efforts. You really don’t want to get hit with a double whammy of both the market collapsing and a major rehab expense you were not anticipating.

Related: The Ultimate Guide to Due Diligence

5. Be More Cautious about Development

Finally, if you intend to get into development, I would be very cautious about it. If an opportunity presented itself, I would be much more interested in one-off development than subdivisions or large commercial projects. I would also want to stress test the project to make sure it worked even if the market took a hit.

I have a friend who got caught with two half-finished subdivision developments when the crash hit in 2008. He lost both of them.

That was not an unusual story at the time. For example, the billion-dollar TOUSA Inc. home builder filed Chapter 11 in January of 2008. Long-term, capital-intensive projects going into an uncertain future are something that should be approached very, very carefully right now.

Conclusion

A (probably) looming recession is not something to radically change your life over. Many people may envision the devastation from the Great Recession occurring again. And while this is possible, it will more likely resemble the painful, but much less so, recessions of 1992 or 2001.

If you adjust your strategy accordingly, try to hold more cash, and proceed cautiously, you should be fine. And hopefully, I will be trying to bury this article sometime in early 2021.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.