You’ve probably heard the word “recession” lately while reading or watching the news. The US economy is in decline for several reasons. Inflation and a declining economy are particularly problematic in the current economic climate. This question raises how real estate investors should approach buying multifamily buildings during a recession.
Next, we’ll address this question and talk about some related factors. More specifically, we will discuss:
- Advantages of Multifamily Investing During a Recession
- Possible Issues with Multifamily Investments During a Recession
- Conclusion
Advantages of Multifamily Investing During a Recession
Demand Increases
Traditional apartment demand rises as the economy slows. The money people have available to put toward housing is reduced during recessions due to layoffs and rising prices. So many would-be homeowners are now stuck in the rental market instead. Some people may be forced to sell and return to renting even if they have a starting home.
The above two reasons are driving up the demand for apartment complexes. For this reason, many multifamily investments are used as a hedging strategy. Put another way, when the economy is weak, apartment building demand rises, boosting the structures’ efficiency. Multifamily performance is typically stable regardless of economic conditions, in contrast to the behavior of more conventional investments such as equities.
Debt Servicing as an Inflation Protector
As previously indicated, substantial inflation is also a part of the current economic crisis facing the US. Said, inflation causes purchasing power to decrease over time. Multifamily mortgages provide some protection against the negative effects of inflation on purchasing power.
Permanent loans for multifamily properties allow investors to lock in fixed monthly payments throughout the life of the loan, both in terms of principal and interest.
Note: If you put money toward your mortgage’s insurance and taxes through your lender’s escrow account, those costs will rise in tandem with inflation.
Let’s pretend you have a $20,000 loan and are making monthly payments of principal and interest. Even after accounting for a year of significant inflation, the price will remain at $20,000. However, your purchasing power will decrease significantly. In other words, due to inflation, your future loan payments will be made with “cheaper” dollars, protecting multifamily investors from economic downturns.
Possible Issues with Multifamily Investments During a Recession
Increases in Interest Rates
We are, unfortunately, in the midst of a stagflationary “perfect storm,” characterized by a slowing economy and accelerating inflation. The Federal Reserve (“the Fed”) will raise interest rates when inflation is a concern. Increases in interest rates can potentially reduce inflation by dampening economic activity.
However, the Federal Reserve’s actions have a domino effect on mortgage interest rates, pushing them upward. The cost of debt can be significantly impacted by even a little increase in interest rates. Increases in borrowing costs of two to three percentage points, as we have seen over the past year, can significantly impact interest payments.
Take a $1,000,000 multifamily investment loan as an example. If you borrow money for ten years at 3% interest and pay it off over 30 years, your monthly payment will grow by $154,373, and your total interest will be $1,482,483. These enormous increases have the potential to render a transaction unfavorable rapidly.
Rising Building Costs
Inflation not only raises the price of essentials like gasoline, groceries, and power but also of more long-term investments like houses. Due to these price hikes, future multifamily developments will be more costly.
For the sake of argument, let’s say that the average hard cost to build a multifamily unit in a given area is $200 per square foot. Allow us to assume that inflation adds 10% to these prices. The preliminary estimated hard expenses for a 40,000-square-foot residential complex were $8,000,000. A 10% rise in such fixed expenses would add $800,000. Investors need to put more money into the venture to offset these rising expenses, reducing their overall return.
Conclusion
Many investors feel cold chills when reading about economic recessions, but diversifying their portfolios with real estate can reduce their exposure to such events. Inflation does provide certain difficulties; that’s true. Even though the economy is contracting, a diversified portfolio with well-chosen multifamily assets can help cushion losses. Investing in stabilized multifamily complexes offers protection against inflation by protecting against 1) higher interest rates and 2) higher construction costs.
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