Investing in a Declining Market: Risk or Opportunity?
A disciplined framework for evaluating acquisitions as pricing resets, from yield spreads and occupancy assumptions to demographics, employers, and fixed-rate financing.
The market is going down. Everyone sees this. The transaction freeze that accompanied the boom years of 2020 to 2022—a sellers' market—and the slump years of 2023 onward—a buyers' market—has come to an end. In recent months, more and more deal proposals have been piling up in my inbox, some even at reasonable prices right at the initial stage of evaluation. Is now the time to buy? Is it a risk or an opportunity?
In the early 1980s, due to high inflation, the Federal Reserve raised interest rates in the United States to as high as 20% to curb inflation that ranged between 10% and 13%. Rates fluctuated between 15% and 20% in 1981 and 1982 and were not lowered until inflation was suppressed.
During those years, the U.S. real estate market ground to a screeching halt. Deals failed to materialize, sellers took properties off the market, and construction companies—unable to secure construction loans—stopped building.
In 1981 and 1982, mortgage rates reached as high as 18.6%. By 1983, the trend had changed, and one could “even” get a mortgage at 13%. Buyers who borrowed at that rate thought they were getting a good deal compared with the peak of 18% or more.
Market solutions were creative. Deals were financed through seller financing or by assigning an older, low-interest loan from seller to buyer. Gradually, as inflation fell—to 3.2% in 1983—the market resumed functioning. It took several years.
After inflation dropped, the main driver of change was demographic. Baby Boomers, born in the postwar baby boom, reached economic maturity and sought to settle down and purchase homes. The result was a massive wave of demand coupled with limited inventory after years of halted construction. By the early 1990s, home prices had doubled. Those who bought toward the end of the 1981–82 crisis did very well.
Viewed from above, there is a clear difference between the U.S. economy of the 1980s and today's. Yet the market's internal dynamics are similar: high inflation is addressed with higher interest rates; high rates slow the market; property owners wait as long as they can and eventually begin lowering prices; and inventory shrinks because construction slows. The knife is falling. Meanwhile, certain markets continue to experience demographic and local economic growth.
So, is executing a deal now a risk or an opportunity? It is possible to purchase property in a declining market, but it must be done correctly. Then a crisis can become an opportunity.
Focus on the spread
We look less at the absolute interest-rate level and more at the spread between the property's yield and the cost of capital. If that spread is positive and sufficiently wide, the deal may be feasible.
Stress-test occupancy
Because we invest in residential rental real estate, our financial model assumes abnormally low occupancy. The more sensitive a property is on the revenue side, the less it is worth to us—and that is reflected in our proposed purchase price.
Understand local demographics
We examine whether the area's population is growing or declining. Residential real estate has a relatively long investment horizon, so local demographic trends have a significant impact.
Fix the cost of financing
Financing should be at a fixed interest rate. You cannot time the market or predict when rates will rise or fall. If the loan term is limited, or the prepayment penalty is structured properly, financing can be replaced when capital-market terms improve.
Follow employers and commerce
We examine major employers near the property, average wages for the relevant property class, and nearby commercial activity. A major employer's decision to locate nearby signals confidence in the area. The same is true when a business such as Starbucks opens close to the property: it has studied the market and identified an audience for its products.
If the sail is not raised when the tailwind returns, it will blow through bare masts while the investment vessel remains still. A deal structured to operate through a declining market can flourish when the positive cycle arrives—and, in hindsight, reveal that a tremendous opportunity was captured.