INVESTMENT PROPERTIES AS A HEDGE AGAINST EXPECTED INFLATION
The Consumer Price Index (CPI) is one measure the government uses to track the rate of inflation in the U.S. economy. Recently, the CPI has been fairly low by historical standards, but some analysts believe that the CPI actually understates the real rate of inflation. One feature of inflation, however, is that the value of debts and other contractual obligations to pay a fixed amount in the future are reduced or discounted as the rate of inflation increases.
Many investors are seeing signs of increased inflation in the near future. For example, commodity prices, as measured by the Standard & Poor’s GSCI, are up about 7 percent in the past year. Food prices have increased by about 20% over the same period. According to the Federal Bureau of Labor Statistics, a pound of ground beef went from an average of $2.23 per pound to $2.77 over the past two years, which represents an annual increase of 12%. Similarly, the price of butter has increased 27% and coffee has increased 16%. Finally, energy prices are around $4/gallon in many places in the country. Given the signs of inflation, what options are available to real estate investors to hedge against a depreciating dollar?
INVESTMENT REAL ESTATE AND INFLATION
Real estate prices tend to rise at a rate that is very close to inflation. A study of the correlation between various asset classes and inflation between 1978 and 2008 shows that real estate returns have the highest correlation. (Source: S&P, Barclay’s Capital, NAREIT, NCREIF, Moody’s Econom.com). Let’s examine some of the variables in relation to inflationary pressures:
- Rental Income: Since commercial and residential rent rates can be increased with inflation, rental property has been viewed as a reliable hedge against inflation. Rents can be increased while mortgage interest rates can be fixed at today’s low rates.
- Property Values: Increasing rents tend to increase the value of the underlying property.
- More Rental Demand: In an inflationary environment the affordability of homes is reduced, leading to more renters. With more renters, comes more demand.
- Financing: When investors have a fixed rate loan, debt service expenses stay the same and investors ultimately end up paying back the loan with less money in real terms than the amount originally borrowed. However, this knife cuts both ways. Higher interest rates make it more difficult and costly for a buyer to finance a purchase.
Although inflation is an important variable, keep in mind that vacancy rates also significantly influence investment returns. An oversupply of product makes it difficult to increase rents. At the same time, when a real estate asset class is under supplied and vacancy rates are low, landlords in that sector have a stronger hand and can raise rents in response to inflation.
POSSIBLE EXCHANGE SCENARIOS WHEN INFLATION IS EXPECTED
Exchange out of bare land, which generates no rental income, and acquire income producing property such as an apartment.
Exchange into multiple single family rentals where rental rates can generally be adjusted every year in response to inflation. Some investors are choosing this approach over long-term leases in assets like NNN replacement properties that typically provide less flexibility to raise rents in an inflationary period.