Inflation is defined as a general increase in the cost of goods and services and a corresponding decrease in value of the dollar.
In the U.S., we’re currently experiencing record high inflation, the highest we’ve seen in 30 years.
But there’s good news, one thing that remains certain in these uncertain times is that real estate is a hedge against inflation. The inflation impact on real estate is a positive one. Although at first glance it seems contradictory, inflation fears are driving more investors toward commercial real estate.
HOW DOES INFLATION AFFECT COMMERCIAL REAL ESTATE?
Commercial real estate offers multiple advantages to investors during times of inflation. Keep reading to discover the key ways inflation affects real estate, particularly how a multifamily inflation hedge is created.
#1 – HOUSING PRICES
Along with everything else, housing prices rise with inflation. For owners, this means their assets will appreciate more quickly. In the current financial climate, property owners are seeing record highs in appreciation. Prices will eventually even out, but even then owners can expect 6-9% increases to remain in many markets.
#2 – MORTGAGE PAYMENTS
Fixed-rate mortgage payments don’t change, but over time the equity in the property grows. During inflationary periods, as housing prices soar, the asset appreciates at an increased rate, yet the monthly payment never changes. Rents on single family homes have been on a steady upward swing over the last year. CoreLogic reported that September 2021 data showed a national rent increase of 10.2 percent year over year, and inflationary pressures will hit the rental market as well.
HOW IS REAL ESTATE A HEDGE AGAINST INFLATION?
At first glance, our discussion here about inflation and real estate investments doesn’t seem to have a positive connotation. In actuality, investing in real estate, more specifically investing in rental properties creates a natural hedge against inflation. In most cases, the investors are not only protected but actually benefit from inflation.
RENTAL INCOME INCREASES
With most investments, like stocks, for instance, the value dwindles during an inflationary period. With real estate investments however, home values and rental prices increase during inflationary times. Having a place to live is a necessity, not a luxury. So, even when prices are at an all time high, people aren’t able to avoid the expense of viable housing.
According to Forbes, the winning formula to profit as a real estate investor during an inflationary period is to tie a cash-flowing property to a long-term fixed interest rate debt. With a fixed rate mortgage on your rental properties, inflation raises the rent payments but the interest payments stay locked at the same low rates, resulting in an increase in cash flow from the property because of inflation.
Rent increases are expected in commercial real estate leases. There’s typically a clause stating that the rent will increase at regular intervals or annually. As rent increases, the value of the property rises as well. If the rent increase outpaces inflation, investors’ return is positive.
As a result, real estate investors typically enjoy an acceleration of returns during periods of inflation. Inflation causes home values to rise, increasing the equity in the asset. The owner of the property then gets an increased rate of appreciation relative to the debt.
Take a look at this example: If, for instance, you invest in an asset with 10% down and inflation rises to 10%, you just doubled your down payment, as well as doubled your equity in the property. At first you might wonder how a 10% increase in profit benefits you if dollars are worth 10% less.
Here’s how it works – the debt on the mortgage is outsourced to the tenants. When you receive a higher return on your equity, despite inflation, and you’re leveraging the fixed-interest on the bank’s loan and the tenants’ income, you ultimately come out ahead.
The price of commercial real estate property is partially driven by scarcity. This is especially true in metropolitan areas where population growth has created a limited supply of space. When demand is high and inventory is low, real estate investors are positively affected, as long as price increases outpace the rate of inflation. Property scarcity is at an all time high in the U.S. currently, and real estate investors are benefiting greatly from the rise in prices, as well as the increased need for adequate housing.
HOW REAL ESTATE COMPARES TO OTHER INVESTMENTS
Real estate investing typically holds less risk than other investments, particularly the stock market, while continuing to deliver good returns and the opportunity to build wealth. For a broadly diversified portfolio, holding commercial real estate is highly recommended. The higher returns gained from real estate investments can offset volatility and/or the lower returns for bonds and mutual funds during inflationary periods.
BUILDING WEALTH IN A POOR FINANCIAL CLIMATE
The sustainability of real estate investing is, particularly during periods of inflation, is one of the top reasons investors are flocking to real estate. According to Forbes, “real estate has made more ordinary people wealthy than any other investment vehicle.”
During inflationary periods, the value of your debt diminishes right along with your equity. Many people are turning their equity into debt by implementing cash-out refinances.
While the general population is searching for some type of hedge of protection against the inflation we’re experiencing in this country, real estate investors are thriving. Investors who understand the advantage of relying on real estate are currently building their wealth at an increased speed. Investing in real estate allows you to use debt to your advantage and continue to build wealth even in a poor financial climate.
Update: May 1, 2022
With recent Fed actions to slow inflation by increasing interest rates, it is becoming more difficult to get long term fixed rate debt that makes sense on multifamily assets. Leverage or the loan to value amount of the loan are decreasing – investors will need to put more cash down to acquire these assets. Accordingly, more syndications will be financed through floating rate bridge debt. Experienced operators will factor in expected (probable) continued rate increases in their underwriting. Deals should now reflect debt costs at 5% to 5.5% in their underwriting. If they don’t, be careful and ask questions.