Understanding Inverted Yield Curves in Commercial Real Estate

For financial analysts, an inverted yield curve is one of the first signs that the economy is headed towards a recession. As noted by Business Insider, all nine major recessions in the U.S. dating back to 1950 have been preceded by one. That doesn’t have to be a bad thing for a commercial real estate investor, though.

Depending on how you play your cards, you can use the onset of a recession as an opportunity. In order to know where you should focus your efforts, you should first know what an inverted yield curve actually is, and why it’s a signifier of a recession. That will help you figure out whether to buy, sell, or simply hold your assets. 

Why and How Does an Inverted Yield Curve Predict a Recession? 

To explain what an inverted yield curve is, we first need to establish how the U.S. Treasury lends out money to investors. Most commonly, this is in the form of an asset known as a bond. Functionally, this takes the form of an IOU agreement between the lender and the debtor.

If you think this sounds similar to a loan, you’re right. The main difference between a bond and a loan is that with a loan, you’re requesting money, with a bond, you’re investing money. Beyond that, bonds are also tradeable. 

While loans are exclusively an agreement between an institution and an individual, bonds are a form of liquid asset that can be bought and sold in approved markets and can readily change ownership. Bonds usually have a guaranteed return, and therefore individually have a lower interest rate and smaller return than loans, as well. 

Bonds generally don’t pay out before their allotted period ends, at which point the payout is usually dependent on how long the bond is locked down. In the case of the U.S. Treasury, the yields are usually 3 months, 5 years, 10 years, and 30 years, respectively. 

Another thing that makes bonds unique is that they can be either long-term or short-term debt instruments. The United States Treasury generally trades in both. In a healthy economy, older treasury bonds have higher interest rates and therefore a higher yield than newer ones. The yield curve, which is a graphical representation of various maturity yields, takes on roughly the shape of a bell. 

As the economy approaches a recession, however, something happens.  Investors begin to lose faith in older, proven bonds, and the curve inverts. There are a few factors at play that may cause this to happen, but it all ties back to the treasury increasing the interest rate on its bonds:

  • People start investing more money in long-term bonds, nervous about slowing market growth and/or increasing market volatility. They may opt to sell short-term bonds to do so, or to take their assets out of the stock market. 
  • As demand for bonds increases, their yield goes down. This has a greater impact on long-term bonds than short-term bonds.
  • Occasionally, the Federal Reserve may choose to increase or cut its interest rate to encourage or discourage the purchase of certain terms of bonds. 

Should You Invest In Property When You See An Inverted Yield Curve?

It’s important to remember that an inverted yield curve isn’t the cause of a recession. It’s an indicator that a recession could be approaching in the coming months, perhaps even in the coming years. With that in mind, the answer is that it depends.

It depends on how your particular real estate market would be impacted by a recession. It depends on how supply and demand in your area look. But perhaps most importantly, it depends on what market or industry triggered the recession. 

The 2008 recession was caused by domestic real estate. By banks issuing mortgages that they knew people couldn’t pay off. As noted in Curbed, The current recession, assuming it even happens this year, isn’t likely to have the same impact on property values, residential or otherwise.

In other words, it will probably be business as usual.

It’s important to remember that no two recessions are the same. They are caused by a multitude of interconnected factors, with the wheels often turning years before the recession actually happens. As such, we can’t really give a solid answer as to whether or not an inverted yield curve represents a real estate opportunity.

However, generally speaking, if you have bonds and you stand on the verge of a possible reception, it may be wise to sell them and invest that money into commercial properties. That way you can preserve, potentially even grow, your portfolio without having to worry too much about the recession’s ravages. 

What Happens to Interest Rates During a Recession? 

During a recession, interest rates tend to decrease across the board.  Per Investopedia, the Federal Reserve has at least some hand in this, tinkering with interest rates in an effort to stimulate the economy and reverse the recession. The goal is to lower interest rates enough that even investors who are skittish about spending their hard-earned money during the recession are willing to pay in. 

Negative interest rates are another thing that’s common during a recession.  Per Investopedia, a negative interest rate refers to a situation in which people storing money in a bank must pay regularly to keep storing that money, rather than. The idea is that people are less likely to hoard money if they have to pay to do it, while banks receiving these storage fees will be more generous with loans that can then be used to stimulate the economy. 

This can be good news for investors, as that means there’s potentially a better chance of getting approved for a mortgage. 

When Was The Last Time We Saw An Inverted Yield Curve?

The most recent inversion of the yield curve was in May 2019, as reported by Forbes. This means that a recession could hit us anywhere from 2020 through to 2022. Either way, it’s likely we are on the verge of a recession, so it’s in your best interests to be ready, whatever that entails.