How Does A Real Estate Crash Affect Your Portfolio?
Andrew Lanoie is a Best Selling Author, Investor and Podcaster at The Impatient Investor, as well as Co-Founder of Four Peaks Partners.
The public perception is that as the economy and the housing market go, so does the rest of the real estate market. With anxiety over a potential housing crash, what would be the possible effect on your portfolio? For insight, let’s look back to the last housing crash that sparked the global financial crisis.
Reviewing The Great Recession
Let’s start with the causes of the housing crash of 2007. Experts agree that there was not just one factor that contributed to the housing bubble. The crash resulted from a combination of factors like the gathering forces of a hurricane that fed off each other until they could no longer be contained.
There is no simple explanation for the housing crash, but I’ll try to put it in layman’s terms. It all started with investor demand for a new kind of mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs). Before 2006, most MBSs and CDOs were related to refinances. This new breed of MBSs was created to expand the mortgage lending box, which eventually pumped $3 trillion more into the mortgage pool for droves of new lenders with relaxed lending standards offering so-called non-traditional NINJA (no income, no job, no assets) mortgages.
These asset-backed securities, which were packaged by banks, were sold to the investing public as fixed-income securities, which appealed to investors because, at the time, they offered higher interest rates than treasuries and carried strong risk ratings from rating agencies.
Fueled by the demand for asset-backed securities, lenders were motivated to originate more and more mortgages leading many to relax their borrowing criteria, giving rise to subprime loans. Fueled by greed, nobody stopped questioning the wisdom of offering loans at high interest rates to borrowers with poor credit.
Subprime loans opened up home-buying to a larger pool of candidates, fueling rabid residential housing demand and driving up prices. Hoping to profit from the real estate boom, investors of all types — individuals, institutional, private equity, syndication — jumped into the fray.
Then, in 2007, the rug got pulled out from under the whole housing house of cards as borrowers started to default on their subprime mortgages, destroying the asset-backed securities secured by these mortgages and everything in their orbit, setting off the global financial crisis. Lenders, borrowers, buyers of the asset-backed securities, investment banks, real estate investors, financial institutions and credit rating agencies were the first groups to get hit. Still, the devastation soon spread worldwide, plunging the worldwide economy into the Great Recession.
In the aftermath of the housing bust, the financial institutions that survived tightened the flow of credit to businesses and consumers, making borrowing more complex and the path to recovery even more daunting.
As history has demonstrated, the residential housing market is closely tied with the broader economy. If one goes, so does the other. But what about the commercial real estate (CRE) market?
With the benefit of hindsight, how did the Great Recession affect the CRE? Probably not how you would expect. Although specific segments such as office and retail took hits due to their close correlation to the broader markets, not all CRE segments or geographic markets were equally impacted. What we can learn from the aftermath of the Great Recession is that the real estate market is diverse and that what happens in the housing market doesn’t necessarily translate to commercial calls. With multiple asset classes and segments across numerous locales — urban, suburban and rural — a downturn in the economy doesn’t affect all classes equally.
While retail and office are more closely correlated to the broader economy, there are asset segments that thrive during a recession, as the Great Recession proved. As people lost their homes, many downsized to multifamily properties in the affordable segment that has seen continually increasing demand and restricted supply since the recession. Self-storage also thrived as a natural consequence of downsizing.
Rewind to the start of Covid-19 induced downturn, and the CRE class demonstrated that not all locations and segments are impacted equally. While many commercial sectors saw increased vacancies and decreased revenues, a couple of industrial and mobile home parks saw reduced vacancies and increased rents.
Even as not all CRE segments are impacted equally in a downturn, the same is accurate about geographic locations. In 2020, locations with less restrictive lockdown measures fared better than others. This demonstrated that CRE markets could vary substantially across cities, regions, metros, etc. Locales that do not rely on a single industry tend to fare better than markets that do, as the Great Recession demonstrated.
Not all investors saw their portfolios devastated by the Great Recession. What can passive investors learn from those who thrived? How were they able to buck the trend?
What We Can Learn
The lesson we can learn from successful investors who survived the Great Recession is that diversification is critical. Putting all your proverbial eggs in one asset and the geographic basket is a recipe for disaster. Diversification across various geographic locations, investment strategies (value-add, opportunistic, etc.), and segments — particularly those that are recession-resistant like affordable housing, mobile homes and self-storage — will not only give you the best chances for surviving but also potentially thriving during a recession.
Besides diversification, another critical factor in surviving a recession is investing with the right sponsors. The right assets in the right locations managed by the right people can make the difference between your portfolio being wiped out and thriving during a downturn.
Nobody knows when the next housing crash will occur. Wall Street wants to sell you on volatility because the public markets are marked with volatility, but as we learned from the Great Recession, investing in commercial real estate the right way can shield your portfolio from the next downturn.
The information provided here is not investment, tax, or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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