Is a recession on the horizon? It depends on who you ask. Everyone has an opinion, from Wall Street to Main Street. This past March, former U.S. Treasury Secretary Lawrence Summers said that he placed the likelihood of a recession in the next 12 months at 80%.
These odds didn’t improve much by June when the spreads between the two-year and 10-year Treasury yields inverted, a historically accurate predictor of recessions. In fact, a survey released that month by the Financial Times and the University of Chicago’s Booth School of Business found that seven in 10 economists polled expect that the U.S. will experience a recession in 2023.
Defining recession
The Business Cycle Dating Committee within the National Bureau of Economic Research (NBER) is the official determiner of recessions and expansions. According to personal finance publication Kiplinger, two consecutive quarters of gross domestic product contraction is often the signal of a recession, but NBER looks at several indicators, such as domestic production and employment.
Signs of a recession also can include declines in real (inflation-adjusted) manufacturing, wholesale and retail trade sales, and industrial production. Kiplinger notes that prolonged declines in production, employment, retail indicators and more will ultimately shape NBER’s definition, but even with these factors, it can take six months or more for NBER to officially determine the start of a recession.
The most recent recession (at the onset of the COVID-19 pandemic) was the shortest on record, lasting two months from February to April 2020. Since 1857, a recession has occurred on average roughly every three years, according to Kiplinger. Since World War II, however, recessions have occurred less frequently — about once every five years.
Thriving under stress
Even with historical data, no one knows for sure when a recession begins until it is actively underway. Private lenders and bridge lenders generally tend to be contrarians. When there is economic uncertainty, traditional mortgage institutions tighten their criteria for lending. In these scenarios, private capital becomes a more attractive funding strategy for commercial real estate transactions.
A prolonged economic downturn is usually defined by its timing, duration and severity. No one variable invokes a recession and there are multiple factors at play.
When economic uncertainty reaches the marketplace, the free flow of capital is disrupted and the amount of available capital tends to shrink. This is when private money fills the gap and these types of lenders thrive. An example of this occurred when traditional lenders stopped funding single-family homes during the Great Recession (December 2007 through June 2009). Private lenders stepped in to fill the void and the industry continued to grow in the ensuing years.
Today, certain asset classes are being impacted more than others. Commercial mortgage professionals saw this scenario play out during the pandemic as office and hospitality were decimated while the retail sector also took a hit. This was a time when large banks and Wall Street investors paused or stopped providing capital altogether.
In many cases, private balance-sheet lenders were able to provide needed bridge capital. Take, for example, the case of a traditional lender rescinding a term sheet and a private lender stepping in to save the deal. The private lender used the equity in several properties owned by the borrower to provide working capital and allow time for stabilization of the new project.
A bursting bubble?
The nation is beginning to see signs of a general slowdown. The U.S. Commerce Department reported that retail sales unexpectedly fell by 0.3% this past May. It was the first such decrease in five months.
At the same time, inflation is impacting everything from gas prices to the cost of food. Consumer spending habits are shifting while some tech giants are conducting layoffs or at least pausing hiring sprees. And the University of Michigan’s consumer sentiment index, which tracks general attitudes among consumers, has fallen sharply this year to its lowest level in more than a decade.
After a tremendous run-up during the pandemic, home prices appear to be slowing as interest rates rise. Even as certain regional housing markets are considered overvalued, it pays to compare them to historic valuations over time as this represents a range and benchmark. Overvaluation of real estate can be a predictor of an economic course correction — but not always. How many times have we heard the question, “Has the housing bubble burst?”
If this scenario is translated to private lending, there isn’t a giant bubble about to burst. Think of it like washing dishes in the sink: some bubbles pop and others simply fade down the drain. Even as the housing market has begun to slow down in comparison to the past two years, there aren’t many comparisons to what happened during the Great Recession, which is a good sign.
Ripple effects
A prolonged economic downturn is usually defined by its timing, duration and severity. No one variable invokes a recession and there are multiple factors at play.
Duration is critical as it determines how much traditional banks will tighten their credit boxes and whether Wall Street will do the same. This directly impacts private lending in both positive and negative ways, depending on how the availability of capital changes. In planning for ripples across the market, private lenders need to examine each loan request on its individual merits and assess risk on a loan-by-loan basis.
These ripples will affect certain property sectors differently. For example, the hospitality and travel industries did well during the second quarter of this year because the federal government gave money directly to people and pent-up demand resulted in strong spending.
In a recessionary environment, if a person has less money, they will naturally spend less on goods, services and entertainment. For sectors such as hospitality, another downturn could be a double whammy on the heels of the pandemic. Retail also is likely to be impacted. But some sectors, such as warehouse and industrial properties, will be more resilient.
These circumstances will create additional opportunities in the marketplace for mortgage borrowers and brokers, specifically for strategic and value-add acquisitions. When less capital is available, it means that bridge lenders and other private funding sources can step in and provide cash more quickly.
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As inflation, more restrictive capital, and other factors negatively impact highly leveraged transactions, participants in various asset classes of the commercial real estate market that have learned from prior economic cycles are anxiously waiting for a correction. On one hand, a correction is damaging to current investors, especially those who used high leverage late in the cycle and continue to struggle with stabilization or an exit strategy. But it also creates more attractive purchase opportunities for seasoned investors.
Although many observers do not anticipate a repeat of the Great Recession, a similar combination of more restrictive traditional capital and stress on existing investors may create additional opportunities for nonbank lenders over the next several years. For private lenders that position themselves correctly, there always will be opportunities to provide capital; it just might look different today than it does going forward. ●
