When a crisis occurs, such as the September 11th terrorist attacks, the global financial crisis in 2008-09 or the outbreak of COVID-19, the media tends to use panic and hyperbole to describe the economic consequences. During the global financial crisis the media claimed the economic malaise would become the “new normal” but it didn't and the economy grew dramatically in the following years. The media is once again using the "new normal" to describe the COVID-19 recession, so don't fall for it. Economic downturns are a part of regular economic cycles and they should be expected. Occasionally we face rapid economic declines brought upon by an unforeseen exogenous shock, such as a terrorist attack or the current pandemic. However, as an investor focused on creating financial independence, it is your responsibility to expect the unexpected and there are ways to protect yourself from these risks which are described below. In addition, there are certain factors you should be watching for in the coming weeks as indications of how severe this recession will become. One issue of particular concern was the decline in April rent payments; if unpaid rents becomes more widespread it will further weaken the real estate sector and cause a contagion effect to other sectors of the economy.
Initial Shocks to the Economy
The COVID-19 pandemic has clearly caused a shock to the economy. Stock values fell by more than 20%, which signals a bear market in equities.* Reuters is reporting a spike of 16.8 million new applications for unemployment benefits. In the short run these factors are not overly concerning as long as they remain temporary. If virus-restrictions on businesses can be lifted soon their operations can resume which should help restart the economic engine. But, if these restrictions remain in effect much longer business owners will need to make painful decisions, including laying off more workers and drawing down on their savings and credit lines to survive. This same process is occurring in households. As people face increasing financial uncertainty they are looking for ways to reduce their expenses. This is where COVID-19 moves from being a temporary economic speed bump to more of a prolonged recession.
Unpaid Rent Will Weaken the Real Estate Sector
In April it was reported that about a third of tenants did not pay rent, and others paid less than the full amount due. Unpaid rent is affecting both residential and commercial landlords. The press is reporting that even well known businesses like Staples, Urban Outfitters and Cheesecake Factory are choosing to not pay rent in April. It is important to remember that we just came out of an 11-year economic expansion with huge corporate profits, a record bull market in stocks, and some of the lowest unemployment levels in 50 years which helped increase both wages and personal savings rates. Its concerning that so many individuals and businesses had 11 years of strong economic growth, yet are not able to pay rent at such an early stage of this pandemic. This may be an indication of more weakness and fragility in the system than was expected, as both businesses and households should have enough savings or access to credit to cover a month or two of rent.
Government Relief Thus Far is Insufficient
Something that is unique about this current economic crisis is how quickly and vocal the government has been on the issue of protecting tenants who fail to pay rent. Congress included provisions in the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) to temporarily block evictions for those who don't pay rent in public housing and in privately owned properties that are financed by federally backed mortgages. Many states have also stepped in to block evictions against tenants who fail to pay rents. This creates what economist call a moral hazard; there are those who truly can't pay rent, but there are also some people who choose not to pay rent because they see themselves as being insulated from the penalties of not paying. There is also some inaccurate advice in the public domain on this subject; these federal and state provisions don't absolve tenants of their legal obligation to pay the rent owed and they don't mean missed payments won't hurt their credit. In fairness to tenants who genuinely can't pay their rent, some are waiting on promised government unemployment benefits and $1,200 stimulus checks which are taking too long to arrive. The government encouraged a movement to block evictions but then failed to provide the necessary financial support to help renters make their rent payments. Also there is a common misconception that all landlords are wealthy enough to weather a period of unpaid rent. In reality, many landlords only own one or two properties while continuing to work a day job. These properties are their version of retirement accounts and they are feeling the same financial pressure of this current crisis as their tenants.
Suffering Landlords Will Lead to More Economic Pain
In an effort to help landlords the government has also passed provisions to protect landlords who currently can’t pay their mortgages. This includes being able to delay mortgage payments as loans go into a temporary forbearance period. However, this relief for landlords is insufficient, as banks are applying it inconsistently or not at all. In addition, some landlords who don't have federally backed mortgages may not be eligible for forbearance options or if they are, their lender is requiring a large balloon payment of all delayed payments once the forbearance period ends in a few months. Many landlords are also concerned that taking advantage of these forbearance options will hurt their credit and access to future financing.
Many banks that originate these loans quickly sell them as collateralized debt obligations to investors. The collateralized debt obligations are managed by loan servicing companies which collect the mortgage payments and then pass them on to the investors for a fee. If rents continue to go unpaid it will have a domino effect, significantly weakening the real estate sector and in turn the broader economy, because real estate is such a significant percentage of our overall economic activity. According to the Congressional Research Service, as of 2018, spending on residential fixed investment was about $785 billion, accounting for about 3.3% of GDP. All spending on housing services, which includes rents, was about $2.6 trillion, accounting for 11.6% of GDP. Combined, this spending accounted for nearly 15% of GDP in 2018. These percentages were similar leading up to 2020.
An Emerging Vicious Cycle
If this trend of unpaid rent increases in May and June, we will see more landlords who can’t pay their mortgages. Some landlords will need to sell their properties, possibly at a loss, which can also result in tenants being forced out. If these conditions continue we will see more mortgage defaults and bank foreclosures, and the shadows of the last economic downturn will start to reappear. Again, this will hurt tenants who will eventually be forced out of their residences and they will have problems finding other suitable housing after failing to meet their previous rent obligations.
A rise in mortgage defaults will lead to tighter lending standards which will bring more job losses across the real estate service sectors including realtors, property managers, home maintenance service as well as those involved in home sharing sites like Airbnb. This is when the downturn could slip into a vicious cycle as new layoffs and business closures have a contagion effect on the broader economy. Those from the suffering real estate sector will significantly cut back on spending. Since two-thirds of our economy is driven by consumer spending we will see a broader downturn in the economy as other businesses and sectors suffer. This is what to watch for in the coming weeks and months.
How to Protect Yourself from These Risks
Despite the current challenges facing real estate and the storm clouds in the economy, it is important to remember two things. First, this too shall pass and second, real estate remains one of the greatest investment opportunities. It is also probably the best way for any individual to climb the economic ladder and improve their lot in life. But, real estate investing must be done correctly to survive these types of downturns. Below are the three key lessons for real estate investing to protect yourself from both cyclical downturns and exogenous shocks like the current COVID-19 pandemic.
1. Plan for Bad Times During Good Times: If you own investment properties you must plan for the long term; this means factoring in the seven lean years during the seven fat years. As housing prices rose dramatically in the last three years it was much harder to find rental properties that could successfully cash flow and turn a profit. When this situation occurs you have two choices, either find ways to add value to a property so you can generate a reasonable return or stop buying properties. When real estate becomes over-valued and good opportunities are scarce, it is a good time to pay down your mortgage debt, so you have the ability to take more loans once prices return to a more reasonable level.
2. Build Sustainable Wealth: To build sustainable wealth, you must mitigate risk by planning for the unforeseeable. Saying an event like this pandemic is unexpected and therefore impossible to prepare for is unacceptable; you have to protect yourself against the unexpected. Here are a few ways to protect yourself from any downturn.
First, for each property you purchase keep cash reserves to cover mortgages expenses, repairs, capital improvements, and vacancy periods. A good rule is being able to cover three to six months of mortgage payments in the event of a recession or long vacancy. This money should not be kept in other volatile investments like stocks; it needs to be where you can access it quickly like in a savings account or money market fund. If you have not saved these reserves, look for ways to increase your cash holdings now so you can ride through the next few months. You may be able to refinance your house to pull out some equity or just lower your monthly payment by extending the duration of your loan. You may be able to secure a personal loan of a manageable amount either through credit card companies or from online lenders. These interest rates can be high so make sure you can service the payments; your goal is to weather the downturn without having to sell any properties. Look for the expenses that you can live without and cancel any services you currently don't need. You don't want to skip on debt payments if possible or you will damage your credit rating when you need it most.
Second, don’t purchase more properties than you can reasonably afford. Newer real estate investors tend to get excited about rapidly building wealth and take on too much debt. In the lead up to the global financial crisis there were people who became real estate multi-millionaires but lost everything when they could not cover their mortgage payments and their banks foreclosed.
Third, set up lines of credit in advance and draw them down at early signs of economic trouble. Keep in mind that lenders often pull lines of credit if a recession looks severe, so draw down this money right away before a lender has time to pull it back.
3. Wealth Changes Hands in Recessions: A key lesson in the book Become Loaded for Life and the corresponding 10 Stages Workbook is to recognize that wealth changes hands in recessions. By following the two steps above you will be much better prepared in a recession and more likely to be able to purchase assets when prices are discounted. If this recession deepens there may be some tremendous opportunities for real estate investors. This is not about trying to profit from someone's loss; when banks repossess a house the former owner has already lost it. The bank now needs sell it to get this liability off their books and as you buy it you are helping to stabilize the economy.
The other aspect of preparing for recessions is learning to live below your means particularly when the economy is doing great. Now is a perfect time to look for ways to reduce your spending and keep these habits when the recession is over. These small sacrifices will prepare you for future recessions as you use these savings to purchase assets which in turn increases your passive income once the recession has passed. The time to buy stocks is when they are in a bear market and the time to buy real estate is when the economy looks most bleak.
Globally we are facing both a health crisis and an economic crisis. For families who have lost loved ones these are emotionally devastating times. In economic terms, our government policies combined with the actions we all take on an individual level will determine the length and severity of this recession. We have more power in our own hands than we realize, and as a society we are not facing anything in COVID-19 we can’t surmount. This is a pivotal time, for us as individuals and as a country, to be better prepared to face such challenges in the future. In the coming weeks we will see more data points on unpaid rents and job layoffs indicating the severity of this recession. Try to monitor them, while filtering out the media's fear tactics and ongoing polemics of political parties. This information will help you to make wise investment choices going forward.
* If you are interested in strategies for navigating the current bear market in stocks see my recent article here.