Is A "Recession" Really Your Friend?

The term "recession" often sends shivers down our spines, conjuring images of economic downturns and job losses. Technically, a recession occurs when we witness at least two consecutive quarters of negative GDP growth—a period of economic contraction. While the repercussions, such as job losses and weakened business conditions, are undeniable, it's essential to recognize the silver lining: the opportunity presented by falling interest rates.

Interest rates are already on a downward trajectory, as illustrated in the recent 10-year treasury yield chart. It stood at nearly 5% in mid-October, has rapidly declined since then to around 3.95%, while I am writing this. This descent is a positive development for Real Estate Equity investments, as the real estate sector heavily relies on financing availability and cost. Falling interest rates, exemplified by the trend in the chart, serve as a significant tailwind for the sector.

Reflecting on the recent economic history, the world faced the sudden impact of the COVID-19 pandemic in March 2020. Governments worldwide responded with unprecedented measures, injecting large amounts of money into the economy, and central banks swiftly lowered interest rates to stimulate recovery. Unfortunately, this aggressive approach led to a surge in inflation.

To grasp the essence of inflation, consider this analogy: if $10 used to buy 10 apples, inflation could result in $20 buying only 5 apples due to supply chain problems. While this is an exaggeration, it illustrates how inflation is generated.

As we stand in the post-COVID era, the effects of the pandemic-induced "helicopter" money have waned. The Federal Reserve's aggressive response to curb inflation has created headwinds for the economy, pushing it toward a formal recession. With consumers strained, savings rates below pandemic levels, and credit card debt doubling, the Federal Reserve is slowly shifting from a hawkish to a dovish stance, projecting three rate cuts in 2024.

The bond market, ahead of the Federal Reserve, has witnessed dropping yields on long-duration treasuries, signaling a consensus among traders that U.S. inflation is steadily decreasing. While the possibility of future volatility exists, the prevailing trend indicates that inflation is now under control.

Looking ahead, the next significant event is an imminent recession and the ensuing falling interest rates. Contrary to common perception, a recession can be a friend to Real Estate Equity investors, as lower interest rates reduce the cost of debt, making real properties more affordable and driving demand.

In the face of rising unemployment during a recession, the drop in interest rates provides a counterbalance. A 1% decrease in interest rates can potentially enable 5 million more people to afford homes. Commercial real estate also benefits, with lower mortgage debt costs resulting in stronger cash flows and support for property values.

The aftermath of the rapid interest rate spike during and post-COVID led to falling cash flows and negative valuations in some cases. The adjustment of Capitalization Rates (CAP Rates) was slow, resulting in a significant decline in commercial real estate transaction volume from 2022 to 2023. However, with the anticipation of lower 10-year treasury yields, owners are optimistic about a reversal of this trend.

To reiterate the main point: a recession can be a friend to Real Estate Equity investors due to the resulting lower interest rates. Despite the recent economic roller coaster, real estate remains a predictable and steady asset class, building wealth over time through stable interest rates during periods of mild inflation.

Looking ahead, the best investment opportunities in the near term are prompting real estate industry heavyweights to favor "Mezz Debt" or "Preferred Equity" strategies. While interest rate trends work in their favor, it might be too early for substantial new positions in Real Estate Equity. Pricing and valuations are still correcting, and the focus on "Mezz Debt" provides equity-like returns with less risk.

In conclusion, while uncertainties persist, the current environment favors a strategic approach like "Mezz Debt." Stay tuned for upcoming projects!