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Ten years into the longest economic expansion in modern U.S. history, concerns over an imminent recession are mounting. Corporate leaders surveyed around the world agree that a recession is the biggest business risk in 2020. Recessions are identified by two consecutive quarters of decreasing gross domestic product and tend to lead to increased unemployment, higher rates of loan delinquency and the loss of value in risky assets such as stocks and corporate bonds.
Individual investors, including homeowners, can prepare themselves for a recession by mitigating the risk in their portfolios. This can be achieved first by maintaining a diversified portfolio of investments and avoiding too much concentration in one asset or in one sector. In addition, avoiding investments in highly illiquid assets that cannot be valued and sold easily can limit one’s downside risk. Finally, holding leverage such as mortgage debt, credit card debt and auto loans carry expensive monthly payments which can be dangerous if income is curtailed.
Homeowners face a unique challenge as it relates to portfolio diversification: A substantial portion of their net worth is locked into a large, illiquid — and often highly levered — asset. Unlike stocks and bonds, a homeowner cannot quickly sell the home and a sale is typically very expensive. And because homeowners commonly use mortgage debt to purchase homes, investment gains and losses are magnified by this leverage. Partnering with an investor in the form of a home co-investment can mitigate some of this risk by selling off a minority portion of one’s home risk while earning an immediate infusion of cash.
The last recession was particularly hard on residential real estate returns, and homeowners may be wondering if that behavior is characteristic or exceptional. In this article, I will show that it is historically unusual for the residential real estate market to decrease in value during a recession.
To help inform expectations, homeowners should look at historical home price changes. Economist Robert Shiller publishes a monthly index that indicates the average performance of residential real estate prices in the United States dating back to 1890. Using recession indicators, published by the National Bureau of Economic Activity, we can see that, on average, homes perform well during economic recessions. Homes decreased in value in only two of the past 10 recessions, two years after the beginning of the recession. In addition, of that entire sample, homes increased in value by an average of 5% over those two years. Notably, the global financial crisis of 2007-2008 was an empirical outlier when homes experienced an average decline of -1.5% over two years.
It is helpful to put these numbers into perspective by comparing home performance to that of the stock market. The S&P 500, an index of large-cap equities, has historically achieved a total average return of 4% in the first 12 months of a recession, marginally better than the 2% performance of residential real estate. However, the downside risk for equities has been significantly higher, with a worst-case scenario of -36%, and four of the 10 recessions resulting in a negative total return over the first 12 months.
A homeowner should be aware of the following critical caveat: Just as individual stocks do not precisely follow the S&P 500 index, an individual home may not precisely follow the home price index. In my company’s Home Volatility Index, we found that, on average, homes experience volatility between 10%-15% in excess of the index, meaning that even if the entire market index has returned 5% in a given year, 35% of homes may have decreased in value.
To conclude, the best way to financially prepare for a recession is to maintain a well-diversified portfolio spanning real estate, equities, bonds and liquid cash. Refrain from utilizing excessive leverage. Avoid running up credit card debts, auto loans, student loans or mortgage/HELOCs. Asset prices typically recover within 24 months of a recession, so as long as debt payments can be serviced without having to liquidate the portfolio, net worth should recover fully in that time frame.