Like many investors, your clients may have concerns about the current economic landscape. Persistent inflation has been frustrating, and higher interest rates have increased the cost of borrowing. Many forecasters have predicted a recession in late 2023 or in 2024, an economic downturn that would surely impact investment portfolios.
Clients may be asking questions (even if they’re not asking you), wondering if they should be making adjustments to their portfolios. Preparing clients for the three risks of inflation, volatility and recession is something you can address. In these “moments that matter,” it’s wise to have a plan designed to protect client portfolios.
Risks facing investors today
Persistent inflation has likely affected nearly everyone in the United States. But it also has an impact on investment portfolios.
Inflation can reduce real returns on fixed-income investments like corporate and municipal bonds. These investments provide a fixed-income stream in the form of interest payments. Because the income stream remains the same until maturity, the purchasing power of the interest payments declines as inflation rises.
Inflation also impacts the underlying value of the investment. As we have seen, higher inflation can result in higher interest rates. As bonds move in the opposite direction of interest rates, higher rates mean lower bond values. The longer the duration of the bond, the greater the interest rate sensitivity.
Persistent inflation challenges the traditional 60/40 portfolio allocation approach, a strategy based on the relationship of stocks and bonds. During inflationary periods, lower risk asset classes like bonds may actually offer less diversification. Bonds can become more closely correlated to stocks when inflation persists, as investors experienced in 2022.
Inflation can also contribute to volatility in stock prices. Because stock prices are influenced by companies’ future earnings, rising costs can hurt corporate profit margins, resulting in falling stock values.
As inflation creates uncertainty about the direction of future interest rates, market growth can become impeded. As we’ve seen, inflation may prompt the Fed to raise interest rates. As higher interest rates discourage business borrowing, fears about the economy can contribute to reduced capital investment and negative market outlooks. Inflationary pressures and the aggressive pace of monetary tightening by the Fed also raise the risk of an economic downturn.
Persistent inflation and rising interest rates could ultimately drive the economy into a recession—which likely means decreased stock values, as companies struggle to maintain profitability. Recession-driven poor results and lackluster corporate earnings can result in negative investor sentiment, and a flight to safety by investors, pushing stock prices down.
All these developments conspire to weigh on investor portfolios, which could result in potentially negative returns. When markets are performing poorly, clients’ portfolio values can decline, giving clients the sense that they aren’t making progress toward goals and those goals seem harder to achieve.
Manage the risks with enhanced diversification
One effective response to concerns about economic uncertainty—whether inflation, volatility, or recession—is to diversify. Specifically, diversify across asset classes beyond traditional, publicly-traded stocks and bonds.
Proactively adjusting portfolios and reallocating assets to enhance current diversification may be a prudent strategy to consider. The idea is to combine multiple asset types—in other words, going beyond the 60/40 portfolio—in an effort to reduce volatility for a target level of return.
The potential benefits of private multifamily real estate in protecting a portfolio
In our opinion, risks like inflation, volatility and recession make real assets, such as real estate, more attractive as a source of returns and a means to diversify a portfolio. While some commercial real estate sectors, like office buildings, have struggled with challenging market headwinds, multifamily real estate has enjoyed strong fundamentals that enable it to continue to outperform.
Multifamily real estate can provide a counterbalance to market volatility, a hedge against inflation, and help recession-proof a portfolio. And the sector is benefiting from steadily growing demand and a limited supply pipeline, which is generating a higher cash flow outlook and better overall performance than other asset classes.
Advantages that are intrinsic to multifamily properties have the potential to make them one of the strongest and most attractive alternative asset classes. And as the multifamily real estate sector has demonstrated resilience during times of market stress, investing in multifamily real estate can be an attractive way to help diversify client portfolios and enhance returns while seeking to grow long-term wealth.
Private multifamily real estate provides several advantages that may be valuable for investors:
- Inflation hedge. Historically, multifamily real estate has been a strong portfolio buffer against the effects of inflation. As the cost of living rises along with workers’ salaries, rental prices also typically rise. Because multifamily uses relatively short lease terms (typically 12 months) that are renewed on a rolling basis throughout the year, operators can raise rents as needed to adjust to inflation, resulting in an increase in cash flow that keeps pace with inflation. The U.S. Bureau of Labor Statistics’ CPI data shows that, since 2017, apartment rents have significantly outpaced overall inflation rates.
- Recession protection. A recessionary environment increases the attractiveness of multifamily investing. Even in times of economic distress, people are likely to prioritize their housing costs. Shelter is a basic human need and multifamily occupancy rates have historically remained steady throughout all market cycles. The average occupancy rate for multifamily properties over the last five years, for example, has averaged 94%. Renters are disinclined to relocate amidst economic uncertainty and remain in rental housing longer. As people look to rebuild credit following a recession, there can be a prolonged demand for multifamily rentals. As renters are priced out of homeownership by high real estate costs and rising mortgage rates, rental housing becomes more in demand.
- Enhanced diversification. Commercial real estate, including multifamily, has historically low correlation to the stock and bond markets. As a result, during market stress, while other investments may be experiencing heightened volatility or sharp declines, multifamily income streams tend to hold steady. And within multifamily investment structures that hold dozens of properties in different geographic locations, diversification is further enhanced, lowering overall investment or portfolio risk profile.
Don’t overlook this diversification strategy
As inflation persists, markets become volatile and forecasts threaten a potential recession, seeking investments that provide consistent, reliable income becomes critically important. Multifamily real estate investing has the potential to provide a variety of benefits that make it an attractive addition to a well-diversified portfolio.
Jay Miller serves as chief investment officer with Forum Investment Group. He has spent the last three decades developing and executing investment strategies focused on driving growth through multifamily debt and equity investing. The views and opinions expressed herein are those of Forum Investment Group senior management and may change at any time without prior notification.