David is the Founder and CEO of Realized, a firm whose mission is to improve lives through innovative investment property wealth solutions.
Understanding macroeconomic risk is critical to a successful real estate investment strategy. While this form of risk is outside of your direct control, you can take steps to manage it, thereby helping to protect your portfolio and investments. Unlike microeconomics, which focuses on household decisions pertaining to disposable income, macroeconomics takes a high-level look at the overall behavior, performance and structure of an economy.
Applied to real estate investing, you may think of microeconomic risk as property maintenance or individual tenant issues. Macroeconomic risk is focused on activities including monetary policy changes, political or civil unrest, population migration and shifts in tax regimes. All of these factors — and more — can have varying degrees of influence on your real estate portfolio.
Considering Economic Cycles
In my experience both in real estate investing and helping others to do the same, I’ve found that decisions to buy, hold or sell real estate should be based on the current economic cycle. However, it is important to recognize that different markets — and property types within those markets — might be at different points in the real estate market cycle. Accordingly, the appropriate investment strategy for a particular property is relative to its position in the cycle. For example, in late 2014, when the price of oil plummeted, the West Texas, Houston and Calgary economies suffered because the majority of jobs in these areas were energy-dependent. Other parts of the U.S. and Canada were far less impacted.
Other Macroeconomic Issues
Credit, liquidity, and interest rates. Liquidity determines how much capital is available for real estate investment, while interest rates tell you how much you’ll pay to obtain debt. The U.S. Federal Reserve sets the overnight fund rates for banks, impacting what a lender will charge to borrow funds. Much like the real estate market cycle, capital availability and cost of capital do not always move in the same direction. In today’s Covid-19 environment, for instance, interest rates are near record lows, yet there is less liquidity than there was six months ago because lending standards continue to tighten.
Unemployment and income distribution. Unemployment is self-explanatory; it is measured by the number of workers who are out of jobs and looking for work. Both high and low unemployment rates can be problematic. The former suggests economic distress, while the latter might indicate economic overheating. Income distribution describes how much income is earned by different segments of the population and is determined by factors such as globalization and technology. Unemployment determines population migration, which can impact real estate tenancy and values. Income distribution is often overlooked but should not be ignored because demand for certain property types may be correlated to certain income brackets.
Government policy. The Fed’s goal is to keep the economy afloat by injecting liquidity into the market. However, an increase in money supply, if unchecked, could lead to an inflationary environment. Fortunately, real estate historically has served as an inflation hedge. Other government policies can have both positive and negative impacts on real estate investors, sometimes simultaneously. For example, the recently enacted CARES Act essentially imposes an eviction moratorium on landlords of certain rental dwellings, even if the tenants do not pay rent. However, the CARES Act also provided stimulus money, which could help tenants pay rent they otherwise might not have been able to afford in the current economic climate.
Examining Demographic Factors
Economic metrics are part of the macroeconomic puzzle. A good grasp of population dynamics is important. People will play a critical role in the performance of your real estate investment.
Population growth and migration, as well as household formation, are residential real estate issues. But much of that is driven by job creation. People move to high-employment areas with low, but not too low, unemployment. This means more demand for rental and owned housing units. An increase in housing owners and renters leads to an increase in investor demand. This, in turn, means your duplex or apartment property could increase in value.
Additionally, there is a reason for the phrase “retail follows rooftops.” The more residents there are in an area, the more retail services they will need. The same holds true for office and medical office spaces: Both of these rely on population increases.
Economies and real estate are also influenced by socio-cultural trends. For example, the rise of e-commerce has boosted demand for same-day and last-mile deliveries. This has led to the development of more warehouses near population centers. Also boosted is investor demand for warehouses and distribution centers.
Ways To Manage Macroeconomic Risk
Risk and reward are the nature of investments. There are, however, some ways to help manage, or reduce, macroeconomic risks to your real estate portfolio.
1. Diversification. Diversification, such as that achieved through Delaware statutory trust (DST) ownership, can spread risk. A diverse portfolio is also good for managing microeconomic risk.
2. Tenants. Creditworthy tenants are generally in better shape to handle volatile economies. This is not to suggest that startup tenants with lower credit scores should be ignored. However, you should know how well tenants operate, both in the current and forecasted economic cycles.
3. Leverage. Debt was one reason for the 2007-2009 global economic crisis. Borrowers financed their real estate with loans in which little if any, equity was required. Lender qualifications are more stringent these days. Leverage can be a powerful tool for increasing returns but is a double-edged sword that can also increase risk. Consideration should be given to the amount of leverage, as well as the terms attached, relative to the position and business plan of the asset.
Real estate investment requires more than due diligence or examining goals. Macroeconomics can impact on your asset, influencing demand, value and rate of return. Knowing macroeconomic risk is essential for successful investment activity and portfolio maintenance.
Full disclosure. The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.