Recently, the financial markets flashed a warning that the U.S. economy could slip into recession within two years. Economists who watch the bond markets spotted an “inverted yield curve," a term for when investors demand a higher yield on short-term bonds than they do for long-term bonds. The presence of the inverted yield curve historically implies a looming recession.
Despite this indication, many investors in apartment properties are relatively confident that they can survive a slower economy without too much strain. They point to strong fundamentals, including low vacancy rates, especially at older, Class-B or Class-C properties.
What's an “Inverted Yield Curve?"
Long-term interest rates are falling once again throughout the U.S. economy. After swelling to more than 3 percent near the end of 2018, the benchmark yield on 10-year Treasury bonds by late March had dipped below 2.5 percent.
That's good news for apartment investors—especially for borrowers. However, short-term interest rates have not fallen as far and are now higher than long-term rates for benchmark Treasury bonds.
Economists call this a “flat" or “inverted yield curve." For example, on March 22, 2019, the 2.49 percent yield on one-month Treasury bonds was higher than both the 2.46 percent yield on three-month Treasuries and the 2.44 percent yield on 10-year Treasuries, according to federal data. Since then, the two rates have wobbled within a few basis points of each other.
That's not usually how it works. Investors usually demand a significantly higher yield for investments that are not scheduled to pay back for a long time. For example, on Jan. 1, 2005, when the economy was still strong and the financial crisis several years away, the 2.32 percent yield on three-month Treasury bonds was roughly half of the 4.23 percent yield on 10-year Treasury bonds.
The yield curve flattens out when economic threats loom in the immediate future. In the past, the yield curve inverted in 2006, 2000, 1988, 1980, 1978, 1973 and 1968. Recession followed an average of 14 months later, according to an analysis in Advisor Perspectives.
The current inversion has not been very steep. Long term and short-term rates are within a few basis points of each other. “The yield curve is not currently forecasting recession. However, we are in the caution zone," Forbes magazine columnist Bill Conerly writes. “Continued Federal Reserve tightening, along with soft credit demand, could indicate a recession in the next year or two.
Strong Demand for Apartments
Even if the U.S. economy slips into recession, experts are counting on strong demand for apartments to continue.
Between now and 2030, the country will need to build 328,000 new apartment homes each year to keep up with the growing number of households that will need places to live, as well as losses to the inventory of rental apartments, according to research from the National Multifamily Housing Council.
Although a few markets and submarkets have become overbuilt, the percentage of vacant apartments is still close to a relatively healthy five percent, on average, nationwide, according to market analysts. Nearly all the new properties opening have been upscale, Class-A apartment towers. Properties like these been forced to offer concessions to lease new apartments in many markets and will be under the most trouble in an economic downturn.
However, more affordable Class-B and Class-C apartments have little or no competition and very low vacancy rates, analysts said. That puts many apartment properties in a relatively strong position—even if the economy slows down.
Opportunity for Investors?
Thanks to the shrinking yields on long-term bonds, the owners of apartment properties have an unexpected opportunity to lock in low interest rates for long-term, fixed-rate financing.
The inverted yield curve also removes the temptation for apartment borrowers to take out permanent loans with interest rates that float. That's because floating-rate loans are typically pegged to short-term rates like LIBOR, which are now relatively high.