Recession and the Real Estate Market

On data as early as September, the Economic Cycle Research Institute (ECRI) has been warning that their Leading Indicators were signaling a new recession. Economic forecasts are notorious for predicting 15 of the last 7 recessions and are unreliable at best. However, ECRI has never issued a false warning and their pronouncement is to be taken seriously; most recently, having called both the beginning and the end of the “Great Recession”. Furthermore, in the summer and early fall of 2010, the economy had slowed dramatically and fears of an informal “double-dip recession” were rampant; ECRI called the slowdown, but refused to predict the US would tip into a recession at that time. Their proprietary forward looking indicators were still dropping as of October 21, 2011 to a minus 10.1, the lowest level since July of 2010 and they are now warning of a global recession. There is a lag from Wall Street to Main Street of about 4-6 months; if Lakshman Acuthan is correct, the stock market will turn down followed by a dramatic slowing in the general economy. At the moment, business activity is still viable and active, but according to ECRI, the US is vulnerable to an economic shock, which could result in an explosive downturn.

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Recession and Real Estate

Real estate cannot escape the effects of a downturn in the economy. Even though there is a diversification afforded by the nature of a distinctly different asset class, real estate and housing are still economically sensitive. The past 4 years have removed virtually all of the oversupply of new construction produced in the frantic bubble years, as well as clearing a huge volume of the distressed and lender-owned properties. A new recession will add to shadow inventory and reduce buyer demand as fewer buyers will qualify. Inevitably, this will put downward pressure on recovering real estate prices across the nation.

Nationally, it will be difficult to quantify the decline as areas such as the Dakotas, enjoying the benefits from both oil and agriculture, will feel little distress. Areas where finance and government drive the local economies, such as New York City and Washington DC, may be hard hit as payrolls shrink to adjust to lower revenues. The luxury home market will suffer both from current homeowners’ loss of income and potential buyers’ difficulty in obtaining Jumbo Loans above Fannie Mae (OTC: FMNA.OB) and Freddie Mac (OTC: FMCC.OB) limits, as risk averse lenders raise requirements to shield from potential losses.

Nick Russo of Russ Trading, www.russtrading.com, an investment adviser with an impressive record of insightful predictions including the real estate bubble and the financial meltdown of 2008, recently suggested a 10% decline annually for the next 3 years. Mr. Russo believes a debt driven event is inevitable and may be imminent, with some estimates of $300 trillion of global public debt and the possibility of $700 trillion in derivatives. Mr. Russo further believes the confluence of social fracturing, political polarization, and deteriorating financial factors have created an unsustainable debt load. The “Sand States,” which were devastated by the real estate implosion, may experience less impact, particularly in the financing favored entry level segments, as those areas have already corrected and in some instances over-corrected. Some properties are still selling at a considerable discount to insurance industry estimated replacement costs.

Mr. Nicolas Russo, who is credited with coining the phrase “The Big Rollover”, has advice for the possibility of a prolonged and deep recession:

1. Keep 3 months worth of expenses in cash; split 50/50 between US Dollars and Canadian Dollars and/or Swiss Francs.
2. 1 year’s worth of expenses in a Short-Term US Treasuries or an ETF such as SHY.
3. 1 year’s worth of expenses in physical gold and silver in 70% and 30% portions.

One’s portfolio should be proportioned:

• 25% Bonds in Ginnie Mae and Emerging Market Debt, not Long-Term US Treasuries which he believes may be in a bubble.
• 15% Gold/Silver ETF’s and stocks
• 25% Strategic Real Estate which would include a personal residence and a Back Door Escape where one’s family may seek refuge if there is social upheaval or chaos. Also included would be cash flow generating discounted residential real estate leveraged judiciously (70% LTV). Mr. Russo warned Real Estate is not as liquid, but represented a value play particularly in the entry level segment.
• 35% Foreign Commodity, Tangibles, Collectibles, and Oil (Mideast disruption), Pipelines, Natural Gas, Growth & Income Conservative Stocks, Utilities; all designed to enhance income.

One of the recurring themes for mitigating the effects of an economic downturn is cash flow enhancements to provide extra revenue streams from investments in a yield starved environment. Strategic Real Estate composed of discounted rental properties, which are still available, could yield to the passive investor a 5%-7% cash on cash net return. In an environment where 30-year Treasury Bonds are yielding under 3%, Residential Rental Real Estate and Commercial Properties tenanted by stable, long-term tenants, particularly a medical industry related tenant could be terrific investments providing income, capital gains potential, and should a conservative amount of leverage be employed, loan reduction. Although no guarantee of future performance, during the “Great Recession” of 2007-2009, the revenue stream from the Residential Rental Properties tended to hold relatively constant and produced consistent income; the value, however, did decline. This is an investment for a 10-15% allocation of the fixed income portion of a well-diversified portfolio with a time horizon of at least 5 years to allow for the potential economic storm to pass.

An economic downturn may not be inevitable, however, there is still time to take prudent precautions. Should the Federal Reserve continue to add to the monetary system, inflation could ignite, in which case, hard assets such as Real Estate will benefit. Should the economy continue to decline, fewer buyers will qualify causing greater rental demand which will result in consistent income. Badly beaten and devastated Residential Rental Real Estate may prove to be the asset class that protects wealth. Strategic Real Estate should be considered as part of a longer term cash generating investment portfolio. Conversely, properties purchased during the “bubble” years or shortly thereafter, those that are underwater and are cash flow negative, need serious consideration for immediate liquidation. These non-cash flowing properties represent a liability and drag on earnings that may jeopardize a portfolio; the short sale process should be fully utilized. Please consult with your financial advisor.

Editor's Note: Article should interest investors in Investors Title (Nasdaq: ITIC), Bank of America (NYSE: BAC), Freddie Mac (OTC: FMCC.OB), Fannie Mae (OTC: FNMA.OB), Goldman Sachs (NYSE: GS), Morgan Stanley (NYSE: MS), Wells Fargo (NYSE: WFC), Toronto Dominion (NYSE: TD), UltraShort Real Estate ProShares (NYSE: SRS), Ultra Real Estate ProShares (NYSE: URE), ING Clarion Global Real Estate Income Fund (NYSE: IGR), Xinyuan Real Estate Co. (NYSE: XIN), Rydex Real Estate Fund H (Nasdaq: RYHRX), T. Rowe Price Real Estate Fund (Nasdaq: TRREX), Toll Brothers (NYSE: TOL), Hovnanian (NYSE: HOV), D.R. Horton (NYSE: DHI), Beazer Homes (NYSE: BZH), Lennar (NYSE: LEN), K.B. Homes (NYSE: KBH), Pulte Homes (NYSE: PHM), NVR Inc. (NYSE: NVR), Gafisa SA (NYSE: GFA), MDC Holdings (NYSE: MDC), Ryland Group (NYSE: RYL), Meritage Homes (NYSE: MTH), Brookfield Homes (NYSE: BHS), Standard Pacific (NYSE: SPF), M/I Homes (NYSE: MHO), Orleans Homebuilders (AMEX: OHB), Vanguard REIT Index ETF (NYSE: VNQ), PNC Bank (NYSE: PNC), J.P. Morgan Chase (NYSE: JPM), Hooker Furniture (Nasdaq: HOFT), Ethan Allen (NYSE: ETH), Pier 1 Imports (NYSE: PIR), Williams Sonoma (NYSE: WSM), Home Depot (NYSE: HD), Lowes (NYSE: LOW), Nasdaq: XNFZX, Nasdaq: FSAZX, Avatar Holdings (Nasdaq: AVTR), Apartment Investment & Management (NYSE: AIV), Equity Residential (NYSE: EQR), Avalonbay Communities (NYSE: AVB), UDR Inc. (NYSE: UDR), Essex Property Trust (NYSE: ESS), Camden Property Trust (NYSE: CPT), Senior Housing Properties (NYSE: SNH), BRE Properties (NYSE: BRE), Home Properties (NYSE: HME), Mid-America Apartment (NYSE: MAA), Equity Lifestyle Properties (NYSE: ELS), American Campus Communities (NYSE: ACC), Colonial Properties (NYSE: CLP), American Capital Agency (Nasdaq: AGNC), Sun Communities (NYSE: SUI), Associated Estates (NYSE: AEC), PennyMac Mortgage (NYSE: PMT), Two Harbors (AMEX: TWO), Simon Property Group (NYSE: SPG).

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