As we enter the second half of 2022, many investors are concerned about the possibility of a recession. If this is a concern of yours, be assured that successful real estate investing is still possible provided the investor uses a different “playbook” to adapt to the new market conditions.
Here are three strategies we’ll discuss for surviving – and prospering – even if there’s a recession.
- Increase your cash reserves
- Focus on recession-proof markets
- Focus on recession-proof tenants
Are we in a recession now?
First of all, are we in a recession right now in September 2022? Some economists define a recession as two consecutive quarters of negative GDP growth, so by that definition we are in a recession, as Q1 and Q2 of this year had negative GDP growth.
For real estate investors however, that is not a very useful definition. Recessions are more than anything else a collapse in the labor markets. In the 1982 recession for example unemployment was almost 10% nationwide. That’s what matters to real estate investors: When your tenant loses his job and can no longer pay the rent; when you can’t find another tenant because people are moving back in with their parents because they lost their jobs – that’s a recession.
Compare that to today. As of this writing unemployment is only 3.5%, the July jobs report showed 528,000 new jobs created in the US in that one month. Nationwide there are currently 10 million unfilled jobs. I would say that currently there is no recession in sight. That doesn’t mean we out of the woods: The Fed’s plan is to keep raising interest rates until something breaks, so we may very well see a recession by the second half of 2023.
Here are three strategies real estate investors can use to adapt to this new market reality.
Three Strategies for investing in real estate during a recession
Increase Your Cash Reserves
The first thing you should do is increase your cash reserves.
I think of investing like football: You have to play defense and you have to play offense. “Playing defense” in real estate means increasing your cash reserves so you can remain liquid if times get bad. For example, if you normally keep three months’ worth of operating expenses in reserve for each property you own, you might want to increase that to four or five months of reserves just in case you get an unplanned vacancy or if there is a maintenance issue. Of course, you can over-do it and tie up all your free capital in reserves, so you have to find a good balance.
Here’s how to estimate your cash reserve requirements:
- For each property that you own, add up your monthly operating expenses: principal, interest, taxes, insurance property management and maintenance. The most accurate way to do this is to look at your statement for the previous year, add up all the expenses and divide by 12. That’s your best estimate of your monthly operating expenses for that property.
- The second step is to determine how many months of operating expenses you need to sleep at night and that’s something only you can answer.
Using myself as an example, I have some brand-new construction homes in Central Florida and I’m comfortable with three months of reserves for each property. My maintenance risk is very low because they’re brand-new homes and still under builder warranty; my vacancy risk is low because the area is growing in population, and it literally takes just a few weeks to find a new tenant. Finally, my hurricane risk is low since they are in central Florida and not near the coast. So for those properties, I’m comfortable with three months of operating expenses per house.
On the other hand, I have some 40-year-old cash flow houses in Alabama that have higher maintenance risk and higher vacancy risk. For those properties I’d be more comfortable with five months’ worth of operating expenses per house.
If I owned properties in coastal Florida where there’s high hurricane risk, I might want to keep six months of operating expenses in reserve per house. Why so much? Won’t hurricane damage will be covered by insurance? Well, that’s true but if a hurricane really devastates an area, many homes will be damaged, and the roofers and contractors will get backlogged immediately. Contractors may not even be able to come out to look at your house for several months. In the meantime, your tenant is living in a motel and you’re not collecting any rent. So, to allow for that possibility, I would keep more cash in reserves for properties with hurricane risk.
As you can see, itemizing the operating expenses is straightforward and objective, but determining how many months of operating expenses you need is very subjective. At the end of the day, you need to be able to sleep at night, so save to the “sleep level” – whatever that is for you. Investing is not worth losing sleep over.
Investing is a series of calculated risks taken from a secure base. If your base isn’t secure (namely you don’t have adequate reserves) then you won’t feel comfortable taking those calculated risks and investing in more properties.
Beef up your cash reserves first.
Focus on Recession-Proof Markets
Once you’re comfortable with your level of cash reserves, now you can play “offense” and go shopping for more properties to build your portfolio. One strategy I recommend if you’re concerned about recessions is to focus on recession-proof markets, and I’ll name a few here.
One example of such markets are markets near military bases. Our Atlanta team has properties in Columbus, Georgia right outside of Fort Benning with 30,000 troops, and properties in Warner Robins, Georgia right outside of Robins Air Force Base with 28,000 servicemen. The Army and the Air Force don’t care about recessions – they don’t have layoffs. By investing in brand-new construction homes in these markets, you have a built-in tenant pool that is impervious to the market cycle.
Another example of a recession-proof market is central Florida near the city of Ocala. Central Florida is the home of The Villages, the largest retirement community in the United States with over 130,000 (mostly affluent) retirees. The Villages just got approval to build another 40,000 homes over the next 20 years which will double its population. I like retirees because they don’t need jobs and are recession-proof. In fact, retirees bring jobs: For every thousand retirees you need so many healthcare workers, so many restaurant workers so many groundskeepers for the golf courses etc. The people who work at The Villages can’t live there because you must be 55 or older and the average home price is almost $400,000. The people who work at The Villages live in the nearby towns like Ocala and Ocklawaha, and those markets are largely recession-proof because they cater to retirees who are also indifferent to the business cycle.
Other qualities that make recession-proof markets are those that have very diverse economies, growing populations and growing number of jobs, such as Dallas, Atlanta and Charlotte. Or markets with a large number of university students, like Ohio State in Columbus OH. Students aren’t affected by the business cycle. By focusing on such markets, you can minimize your downside risk and continue building your portfolio.
Focus on Recession-Proof Tenants
The final strategy will discuss here is to focus on recession proof tenants.
The military tenants I mentioned earlier are an example of recession-proof tenants. Large student populations in university towns are another.
Another example would be Section 8 tenants. The Section 8 program pays rain or shine, and it doesn’t matter what the economy is doing or if unemployment is 5% or 10%. During the Covid pandemic many landlords had to deal with tenants who lost their jobs and couldn’t be evicted because of eviction moratoriums, whereas landlords with Section 8 tenants got their rent payments from the government on the first of the month, like clockwork.
Another group you might consider will which is not quite recession-proof but perhaps more recession-resistant are healthcare workers: nurses, paramedics, medical technicians etc. When people are sick or injured, they need healthcare regardless of whether the economy is in recession or not.
All of these groups have recession-resistant qualities; when filling a vacancy or when considering a new property purchase, speak with your property manager and ask if any of these tenants are viable options. Fill your vacancies with tenants who are resilient and less likely to be affected by recessions.
Recessions happen about every 10 years in the United States – they are just a normal part of the boom-and-bust business cycle. They’re not the end of the world. As part of your investor playbook, you should know how to deal with recessions so you can continue building your portfolio regardless of market conditions.
The doomsday scenario for real estate occurred in 2008 when the entire financial system was on the verge of collapse, yet many real estate investors were still making money by buying properties $0.50 on the dollar. That wasn’t their plan going into 2008, but when market conditions changed, the smart investors pivoted and changed their strategy to meet the new market conditions. Investors who sat on the sidelines didn’t make a penny (though they didn’t lose a penny either).
We real estate investors have been spoiled these last couple of years with near-perfect investing conditions such as artificially low interest rates and rising prices. But if you look at any 20-year period of economic history, conditions were ideal for investing maybe four or five of those 20 years. Most of the time, something less than ideal is going on: Either there’s not enough inventory or there’s too much inventory or interest rates are going up or there’s a recession on the horizon, or something else. As an investor you should be able to pivot and shift your strategy so that you can be a successful investor in almost any market. If investors can make money in 2008, they can certainly make money in 2022 and 2023!
The three strategies we discussed today for how to invest in real estate during a recession – build up your cash reserves, focus on recession-proof markets and focus on recession-proof tenants – should be part of your “recession playbook” for this and future recessions.