Are housing prices going to drop over the next while with an incoming recession…?

I think first it’s best to take a step back and look at the context. Some house prices are going to drop – mainly those that are in overpriced bubble markets – If I had a $2m condo in Toronto with a 4% net yield, then I’d be selling that – it’s overpriced froth in a speculative market.

Fortunately, what we’re buying couldn’t be more different. Lets look at the subject from a few different angles – 

AFFORDABILITY

Here’s a useful graph –

Notice that 5 out of the 10 most affordable markets in USA are where we buy. We aren’t buying hipster pads in Austin, Texas here. Our focus is on a resilient niche that can continue to thrive through the coming years – essentially recession-proof real estate. 

Our net yields are over 10% and our entry price is generally under $100k. 77% of purchases under $100k are in cash, so interest rates have a much smaller effect on the market than, for example, the mid-level owner-occupier sector.

NET YIELD IS THE DRIVER OF PRICE IN OUR MARKET

Rather than interest rates and owner occupier affordability, I think it’s best to focus on the long-term drivers behind real estate investment, even residential, and you’ll find that inflation is our friend for assets like ours, because house prices in the investor market are driven by net yields, not interest rates.

I think once you understand that (like with commercial real estate) our values are driven by net yields, and an inflationary recession will improve our net yields and therefore drive values up long term, then any long-term concerns about ‘house prices going down’ dissolve.

INFLATIONARY RECESSION EXAMPLES AND SCENARIOS

Here’s an example of one of our houses (its 200 yards from my own house in Buffalo) .

We bought this for $110k earlier this year and spent $10-15k upgrading and rehab. Current value around $180k so plenty of equity in there (our LTV isn’t actually that high because we’re quite aggressive in pricing offers) Rents $1080 each unit (net rent is circa $1400 per month) So even at its current (much higher) market value, net yield would be 9.33% 

The obvious point from this is that the same size house would cost $250-350k to build now, so no new supply is coming onto the market at that level. If we indeed do go into a recession and people tighten their belts in terms of housing, then our rental demand increases, while new supply is zero. The ‘natural’ value of a house would be at least the cost to build a replacement, plus land value, and we’re buying at well below this. 

My overall thinking is that this recession will be different from the last in that unemployment won’t spike, but inflation will mean that wages will keep having to rise to cover increasing cost of living (including increasing rents)  The tenant pool will rise in quality and quantity as people will hold off buying, while no one with a 3.1% 30 year fixed mortgage will be rushing to sell (keeping inventories in check) Less buyers, less sellers.

So, let’s look at a few inflationary recession scenarios – 

-What will happen if house prices in our niche do fall?

This should push net yields up and make purchases more attractive for us – good time to buy aggressively. If net yields at 15%+, it makes it very attractive and a flood of money flows into the market.  This is a very different scenario from the hypothetical $2m condo in Toronto – that will be cash flow negative and would revert to its real value (a net yield much higher than current, and a much lower value).

-What will happen if Inflation continues for a long time?

This should mean rents continue to rise with inflation and bring net yields up – again totally fine for us since it erodes the value of our debt and improves cashflow.

– What will happen if Interest rates go to 9% to combat runaway inflation?

This means wage inflation is also likely to be high = can continue to increase rents in line with inflation and increase net yields.

Conclusion

In short – Investment grade housing driven by Net Yields can be an attractive store of wealth in an inflationary recession, as opposed to overpriced retail level housing. Coming out of that cycle is also positive but that’s a subject for another time.