America has suffered a recession every 4.9 years on average since World War II. It has been eight years and eight months since the global financial crisis, making this the third-longest recovery between recessions in U.S. history. By March of 2018, assuming the next recession does not begin before then, the current recovery will become the second-longest in history. Simply put, based on historical cycle lengths and a number of economic and market indicators, we are extremely overdue for another recession and market correction.
As we learned all too well during the global financial crisis, investments that are highly dependent on economic growth and that do not provide a defensive cushion for macroeconomic and market downturns are a recipe for disaster. To protect investor capital, we must not only complete thorough due diligence on individual offerings, but also take into account the impacts that macroeconomics, capital markets and real estate cycles have on the particular real estate investments under consideration.
We must recognize the cyclical nature of the economy, capital markets and real estate — each of which experiences ever-repeating cycles of expansion and contraction. Periods of excessive valuation and growth are generally followed and corrected by periods of severe contraction. Investing at, or near, the peak of the former generally leads to significant and often unrecoverable losses during the latter. There seem to be many indicators signaling that we are at or near the peak in this current economic and real estate market cycle.
For example, across almost all asset classes, real estate prices today have reached higher valuations in both relative and absolute terms than what we experienced back in the 2006 and 2007 peak prior to the global financial crisis — a peak of historic proportions. Cap rates, rent growth, occupancy levels, concession levels, rents as a percentage of income for apartment renters, employment levels, corporate profit margins and consumer debt levels have all reached market cycle extremes. All of these factors are cyclical and all of them are indicating that we are at or very near the top of the market.
This is the time to be both cautious and defensive in our due diligence and investment strategies. However, classic market psychology generally induces investors to pursue the opposite of what is in their best interest at the worst possible time. As markets near a peak, investors tend to become more enthusiastic and aggressive, throwing caution to the wind at the very time they should be conservative and defensive.
We are seeing this exact psychology play out in the market today. Peak market multiples are being paid for market-cycle-high income levels. In general, we are seeing the extrapolation of past growth into pro forma, projecting uninterrupted and compounding growth over the next decade with absolutely no cushion for normal operational issues, let alone a recession. Investments are highly dependent on aggressive economic and organic growth to dig out of the deep hole created by today’s extremely low cap-rate environment. It seems that we have forgotten the lessons of the global financial crisis — markets are still cyclical and what goes up must eventually come down.
Paying peak market cycle multiples on peak or even above-peak market cycle income assumptions with market-peak aggressive debt levels and terms typically ends in disaster. The result is almost always the same. You need only look back to the real estate market crash in 2008–2010 to get an idea of what lies ahead of markets that correct from overvalued extremes.
If history is any guide, we should consider the characteristics and aftermath of the only two recovery periods longer than our current one: the 1960s and 1990s. The expansion of the 1960s lasted eight years and 10 months. It was built on the technological boom of America’s space race against the Soviet Union and the productivity boom of women entering the workforce. The 1990s were fueled by a combination of the Internet and personal computer revolutions resulting in a total recovery and expansion period between recessions of 10 years. It should be noted that both the 1960s and 1990s recoveries were followed by significant market corrections and nearly decade-long economic stagnations. Is that what lies ahead of our current overextended recovery period?
No one has a crystal ball that can predict the exact timing and depth of the next market downturn. All anyone can do is look to market indicators and probabilities to get a general idea of where we are in the market cycle. If anything, it is prudent to lean toward the conservative side of the spectrum and prepare to weather the storm that history indicates is inevitable, rather than get caught unprepared.
Recessions are inevitable. The question is not if but when and how deep the next recession will be. The evidence seems stacked in favor of experiencing a recession sooner than later — and one that is deep rather than shallow. The key is to prepare in advance and to stress-test every investment being considered with the expectation the next recession is going to be severe. If history is any guide, those precautionary measures will ensure you are prepared.
Given where we are today, with economic cycles being considered, and with extreme levels of overvaluation in the market, it is crucial for real estate sponsors, advisers and investors to proceed with an abundance of caution. All assumptions must be questioned and evaluated. Acquisitions and investment strategies must be built to weather the coming storm. Investment strategies that depend primarily on strong economic growth to sustain their income and protect investor capital should be reconsidered.
Real estate investments in general suffered significant losses of income and capital in the most recent market downturn and recession. Let’s ensure that we learn the lessons of the past so we do not repeat the same mistakes.
Joshua Ungerecht is a managing member of ExchangeRight Real Estate.