Courtesy of Michael Douville, Realty Executives
Written: December 27, 2011

No alarm goes off when the economy enters a recession; there is no bell or bright flashing red light. Rather, it is stealthy and silent; activity slows imperceptibly at first and then gathers momentum at which point it is generally too late to make portfolio changes and preparations. As a point, the “Great Recession’ is believed to have started in December of 2007, two months before the Dow hit its all-time high of 14,164 on October 9th, 2007. In my opinion, a recession is coming; a deep, nasty, global recession that will affect all corners of the business globe. It may already have started.

If, as I suspect, a recession has indeed started, it will be the first in memory that was not induced and controlled by the Federal Reserve. Typically, the Federal Reserve would monitor business activity and would raise interest rates to dampen an economic expansion and prevent an outbreak of inflation; money supply was withdrawn, and eventually the combination of increasingly higher rates and reduced money supply would contract the economy; the result was a recession. When the economy had cooled, rates were lowered, liquidity restored, and the economy successfully recovered.

This time it is very different. The Federal Reserve is pouring liquidity into the system and rates have been dropped to near zero with nowhere to go; the Federal Reserve is not in control of this Recession. This will be a debt driven recession and there is no recent experience with which to compare the outcome. Further, unemployment in the beginning of a typical recession is generally low starting from an expanding business climate. This may be the first time unemployment will start into a recession as high as 9% nationally. As the slowdown progresses, more and more workers will lose their jobs and unemployment may reach as high as the mid-teens.

Recessions feed upon themselves; business activity slows, which affects incomes from employment. The stock market declines which affects income from capital gains and sometimes dividends. Prices for commodities and finished goods decline leading Master Limited Partnerships (MLP’s) to lower income. Interest rates are near zero so income from CD’s and Money Markets are inconsequential and Treasuries yield little. But rates may even decline from here, so capital gains may be achieved in fixed income investments, but with very little income.

Revenue to pay the bills becomes paramount to surviving an economic slowdown. Reserves are to be used as a last resort, as depleted savings are difficult to replenish. Even in a severe recession, most people are still working. In the Great Depression, unemployment reached as high as 25%; that meant 75% were still employed. The situation becomes dire for those out of work as jobs become more and more scarce and precious. Basic needs still exist, and so industries providing food, shelter, health care, and energy may still deliver returns. If the recession of 2008-2009 can be used as a guide, Strategic Real Estate may also be a safety net.

In the beginning of the last recession in early 2008, rental rates started to decline as unsold properties were forced into the rental pool, adding to the supply. Further, construction workers and undocumented laborers left the construction sector and searched for work elsewhere compounding the vacancy factor. The decline was limited; without additional new construction, within 6-9 months, the supply started to be absorbed and currently the inventory of available rental properties is tight. Rates declined about 15% initially, but the decline was mitigated by an offset in insurance rates, property taxes, and repair costs. Within two years, the rental rates were recovering.

Every recession is different. However, as a primary need, residential rentals may provide a consistent source of income. With rates at historic lows and prices still not recovered from the devastation of the collapse, cash flows have been excellent, with typical returns in the 5-9% range. If current policy continues prohibiting former home owners that have liquidated properties via the short sale process or through foreclosure from purchasing another home for at least 2-4 years, a constant supply of new long-term tenants is assured. Strategically purchased cash flow producing properties will benefit the investor with consistent monthly income and potential capital gains as the economy eventually transitions from recession to recovery. Rental property would also provide a shield of protection should a recession provide an opportunity for the Federal Reserve to flood the economy with unprecedented capital to move the environment from deflation to inflation, and maybe hyper-inflation. Furthermore, deflation is mitigated by the income enhancing properties of a basic needs investment.

There is still time to prepare; a prudent investor can protect his portfolio by limiting exposure to traditional risky assets, and adding to currency equivalents like gold and silver. Also, negatively correlated ETF’s can be used to mitigate a possible downturn, and income enhancers such as basic rentals can be acquired to provide monthly income streams. In our view, a portion of a diversified portfolio should benefit if it were to be allocated to Strategic Real Estate of the sort we suggest here. Any non-cash flowing or underwater property owned by the investor needs to be reviewed, and we believe any property that cannot be justified for its investment potential needs to be liquidated immediately!

Consult your licensed financial advisor of good reputation and integrity before making investment decisions, as a good advisor will learn your individual situation, needs and current exposure, and help find the best route forward for each individual as a result.