As a real estate investor, it’s essential to keep an eye on financial markets to ensure that your investment decisions are well-informed. One term that you may see frequently in headlines these days is “yield curve inversion.” In this blog post, we’ll discuss what an inverted yield curve is, its implications for financial markets, and how it affects real estate investing.
What is an Inverted Yield Curve?
The yield curve is a graph that shows the interest rates of bonds with different maturities. Typically, the yield curve slopes upward because longer-term bonds have higher interest rates to compensate for inflation and the risk of holding the bond for a longer period. However, when the yield curve inverts, short-term bond yields become higher than long-term bond yields.
An inverted yield curve is a strong indicator of an economic recession because it implies that investors have lost confidence in the short-term economic outlook. In other words, investors expect interest rates to decline in the future, so they buy long-term bonds to lock in higher yields now. Yields fall as bond prices rise, and bond prices rise as investors buy more of a given term of bond.
Keep in mind that an inverted yield curve does not cause a recession. Much like other “wisdom of crowds” phenomena, the collective perspective of investors tends to be predictive.
What does an Inverted Yield Curve Mean for Real Estate Investing?
Historically, an inverted yield curve has been a reliable predictor of an economic recession. According to the Federal Reserve Bank of San Francisco, every recession in the US since 1950 has been preceded by an inverted yield curve. As a result, the stock market tends to decline when the yield curve inverts because investors are fearful of an economic downturn.
However, most commercial real estate asset classes tend to perform better than the stock market during a recession because returns are more driven by demand in the real economy, versus in public markets where share prices are partially driven by market sentiment.
Additionally, real estate asset valuations tend to be driven by interest rates. High present interest rates and the fear of recession may create opportunities for forward-looking real estate investment firms. Experienced operators can manufacture returns by acquiring properties at an attractive basis and selling in the future at a more favorable moment for capital markets.
Understanding an Inverted Yield Curve
Inverted yield curves do not happen often, and they are relatively rare occurrences. Therefore, when they do happen, it’s crucial to pay attention to their implications for financial markets. When an inverted yield curve occurs, it suggests that investors expect lower interest rates in the future, which can result in a decline in the economy and stock market.
As a real estate investor, you can use the information from an inverted yield curve to your advantage. Consider further diversifying your investment portfolio. Ensure that you have enough cash reserves to seize on any kind of opportunistic investments as they emerge during a downturn. You can also look for investment opportunities in markets that are less likely to be affected by a recession, such as rental properties in stable markets or commercial real estate that is less dependent on the consumer economy.
Potentially Recession-Resistant Asset Classes
If the inverted yield curve does prove prescient and we do see a recession, certain commercial real estate sectors potentially provide a “counter-cyclical” investment thesis and could be worth considering as timely additions to your portfolio. Here are a few examples:
Multifamily
No matter the overall economic outlook, people always need a place to live. Further, when recessions bring pessimism, people tend to rent rather than buy. Multifamily has historically performed well during recessions versus other asset classes. As of early 2023, high mortgage rates may also incentivize would-be homebuyers to rent instead, creating more demand for multifamily. For more on multifamily during recessions, please refer to this article.
Self-Storage
When recessions hit, both consumers and businesses may downsize and lean on storage units to house their belongings. Self-storage facilities also tend to be light on operating expenses and complexity. Self-storage operators can also “mark to market” quickly, as units turn over frequently. Hence, this is also a potentially strong inflation-hedged asset class.
Medical
Medical care is an essential good. No matter the severity of an economic downturn, the population will need medical care. As the population of the U.S. ages, demand for medical care should grow. Several “niche” CRE asset classes stand to benefit from this trend: medical office buildings and assisted living facilities in particular offer a durable investment thesis.
Again, an inverted yield curve does not necessarily mean a recession. To position yourself for a potential recession, these types of real estate may be worth considering.
The Bottom Line
An inverted yield curve has been a reliable indicator of economic recessions. Real estate investors need to understand the implications of this leading financial indicator. While the stock market tends to decline when the yield curve inverts, real estate can still perform well during a recession. It’s essential to stay informed about market trends and to diversify your investment portfolio. In volatile times and recessions, exposure to alternatives can help to balance risk.
