Last Updated: January 22, 2024
Since 2020, inflation has surged onto the radars of economists, mainly brought on by considerable increases in material costs, consumer goods prices, and rents. Massive government stimulus measures intended to cushion the economy during pandemic-related shutdowns were followed by significant increases in material costs, consumer goods prices, and rents. In this context, many often ask or even try to find out whether real estate is an effective hedge against inflation. They try to understand just how the mechanisms towards the protection of inflation do their work and may even identify the best strategies to guard their money against the decrease in the value of money.
Indeed, private real estate provides a sturdy way out, especially in asset classes such as multifamily apartment communities. These are investments that offer significant tax benefits, very similar to that offered in private and direct ownership, but rank very high as a recognized and favored key asset class for capital preservation. Multifamily real estate is stable, and the cash returns on the investment from day one are through cash flows. Stabilized and valued properties at market rates or under value-added terms allow us to get a higher return rate than the one with which the dollar is devalued. Another critical concept, the time value of money, with cash-flowing assets, effectively embodies this principle. Specifically, in times of inflation like the current environment, not only do property values rise in price, but the rental rate does as well; this serves as a hands-on hedge against inflation.
This guide seeks to investigate the nature of inflation, outline four pivotal reasons that make real estate the most effective hedge against the disease, examine how leveraging real estate debt can prove beneficial at inflationary times, and much more.
Key Takeaways
- The purchasing power of $1,000 in 1980 would now necessitate approximately $3,260 due to an average annual inflation rate of 2.94%.
- In the United States, inflation is quantified using the Consumer Price Index (CPI), which evaluates the escalating costs of a diversified basket of goods, including food items like cereals and milk, beverages like coffee, medical services, toys, and more.
- Engaging in robust market investments can yield a natural rent increase of about 2%-3% annually, effectively countering the typical inflation rate and sustaining demand stability.
- Real estate distinguishes itself by offering dual facets of intrinsic value: both elements are scarce and cater to essential human needs.
- Properties such as multifamily real estate epitomize this by not only maintaining their inherent worth but also appreciating in value, elevating income through higher rents, and benefiting from the depreciation of debt.
What is inflation?
Inflation is the general rise in prices of goods and services in an economy over a given period. This, therefore, erodes the purchasing power of money. Typically, inflation is expected to rise between 2% and 3% annually. This systemic increase means each dollar holds an increasingly lower value each year.
To put things into perspective, $1,000 back in 1980 would today be worth some $3,260 if it had been invested with an average annual inflation rate of 2.94%. A factor that has brought concern is the trend where the cost of living continually increases faster than the growth in wages. Historical peaks in inflation, such as the 13.5% rate experienced in the 1980s, suggest that at certain times, it may increase well above the average.
How is inflation measured?
In the US, inflation is measured based on the Consumer Price Index (CPI). The measure considers the cost changes regarding a predefined basket of goods and services, otherwise known as the basket of goods. That basket consists of different items: food, beverages, cereals, milk, coffee, medical care, toys, etc. It reflects the variety of pricing dynamics for consumers.
However, the CPI is far from perfect, and many times, a number of essential items are found missing, hence giving a biased indication of overall inflation measures. Despite all the weaknesses mentioned above, the CPI is central to several governmental statistics that affect a variety of critical public programs.
Economists often stress a crucial point of difference: the government projects, officially, an annual inflation rate of 2% to 3%, but officials at all levels do not capture the rate of inflation at all levels. Critics insist that is the incentive of a government to underreport these figures. This would mean that even higher inflation would, therefore, mean spending even more of hard-earned tax dollars on important social programs such as Federal Civil Service retiree benefits, social security payments, and food stamp programs. This underreporting potentially affects the level of funding required to enable these programs to stand alone.
The Coronavirus Pandemic and the Inflation Rate
Above is the M-1 Money Supply from 1959 to 2021
This is where the Federal Reserve had to take recourse to quantitative easing (QE) to fight off the economic fallout emerging due to the COVID-19 pandemic. Under this strategy, the Federal Reserve made purchases of assets on a huge scale, increasing the money supply in the U.S. In 2020, the money supply increased by a whopping 30%. One notable action included the passage of the Coronavirus Aid, Relief, and Economic Security (CARES) Act on March 27th, 2020. A $2.2 trillion economic stimulus bill, the act was meant to provide a bulwark to the economy under the new onslaught of the pandemic.
As is evident above, the role the U.S. Senate has played is critical in infusing trillions of dollars into the financial system to be able to increase the money supply. This measure has aimed to jumpstart not only economic activity but has also resulted in the downfall of the U.S. dollar.
Above is the Consumer Price Index (CPI) from 2011 to 2021
Is Real Estate a Hedge Against Inflation?
Assuming you were to have acquired the property in a well-endowed market, your rental income is expected to increase by an average of 2%-3% annually. This growth acts as strong protection against inflation; it keeps pace with normal inflation rates of 2-3%; hence, your investment does not lose the purchasing power it represents. It is, however, worth noting that external forces may have a huge influence on the market. For instance, in 2021, the country experienced a severe lumber deficit due to lumber prices surging by 400%. Such a situation, in its turn, created an aggravated housing deficit.
Leaving your hard-earned money in a savings account only makes it vulnerable to silent erosion. Since inflation gradually reduces the actual value of money, what remains becomes less valuable over time.
For Example: Imagine inflation is at 5%, and your money in the bank earns a measly 1% interest rate. In this scenario, your purchasing power would actually decrease by 4% year-over-year.
There are four core reasons why real estate is a hedge against inflation, and they are as follows:
- Intrinsic Value
- Appreciating value
- Increase in income/rents
- Depreciating debt
1.) Intrinsic Value
Real estate stands out as a hard asset compared to its more volatile counterparts, such as stocks and bonds. This is in stark contrast with this set of financial instruments since real estate has inherent value due to the fundamental character of its limited supply.
Consider that while things like oil and natural gas have value since they can be traded or used as products, the value of paper money can crash to zero if supplied in excess, and it has lost its utility.
We address two different but interconnected parts with an appeal to the intrinsic value of real estate, with a constrained supply of each and serving two basic human needs. These two intertwined but separate parts are detailed in the following section.
- The Land
- The Building
One of the cornerstones of real estate’s intrinsic value is land scarcity. There is a finite amount of land available, making it a naturally precious resource. This inherent limitation significantly contributes to real estate’s value proposition.
However, the equation extends beyond just land. The U.S. currently grapples with a critical affordable housing shortage, further driving up property prices. A key factor contributing to this supply constraint is the escalating cost of developing new units. Inflation, for example, significantly impacts construction costs, making it increasingly challenging for developers to deliver affordable housing that meets their financial return expectations.
This dynamic has a fascinating ripple effect. As building new units becomes cost-prohibitive, the value of existing buildings rises. The reason? The replacement cost to construct the exact same property type today would be substantially higher, factoring in inflated development costs. Additionally, building such units might carry a higher risk profile for developers due to potential market fluctuations.
2.) Appreciating value
For real estate investors, asset appreciation is a cornerstone of building long-term wealth. Long-term investors are positioned to benefit from rising property values by strategically acquiring and diligently managing the right properties.
Market trends often favor patient investors. Cap rates, which reflect the rate of return on an investment property, tend to compress nationwide over time. This means that investors can expect the value of their assets to climb as cap rates decrease. Additionally, widening cap rate spreads can signal opportunities for even more significant value creation.
Here’s a critical point to remember: natural rent growth is directly linked to asset values. As rents increase over time, so too does the overall value of the property.
Let’s illustrate this concept with a simple example:
Imagine a property generates a Net Operating Income (NOI) of $500,000 annually.
- With a capitalization rate (cap rate) of 9%, the property value would be $500,000 (NOI) / 0.09 (Cap Rate) = $5,555,555
- If the cap rate decreases to 8%, the property value would increase to $500,000 (NOI) / 0.08 (Cap Rate) = $6,250,000
This demonstrates how a seemingly small shift in the cap rate can translate to a significant increase in property value.
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3.) Increase in income/rents
In stable real estate markets, rental prices and, consequently, rental income tend to exhibit a natural upward trend of 2% to 3% annually. This growth serves as a valuable hedge against inflation, effectively offsetting the impact of inflation, typically ranging from 2% to 3%. However, the equation isn’t entirely passive. As inflation increases, it can lead to rising housing costs and higher expenses associated with operating an apartment building. Landlords may need to adjust rental rates to account for these operating expenses to maintain profitability.
4.) Depreciating Debt
Inflation gradually diminishes the purchasing power of money, reflecting a consistent annual devaluation. Acknowledging that a currency’s current value exceeds its future worth is crucial.
Those who secure loans for their real estate ventures effectively repay their lenders with funds that depreciate in value each subsequent year. Specifically, the principal amount of the debt diminishes over time. Among commercial real estate segments, multifamily properties stand out for their robustness and ability to align with the pace of inflation. This allows property owners to adjust rents annually in correlation with the typical rise in inflation rates.
As the prices of tangible assets escalate, their overall value increases, thereby expanding the disparity between the original amount borrowed to purchase them and their current market value.Top of Form
Has real estate been a good hedge against inflation, and will it be in the future?
Real estate has consistently served as an effective hedge against inflation, maintaining its resilience across varying interest rate scenarios. The accompanying graphs illustrate how rental prices have historically surged, particularly during significant inflationary periods in the 1970s and 1980s.
Presented above is the Consumer Price Index (CPI) spanning from 1950 to 2022. Notably, inflation reached a peak of 13.5% in 1980.
A chart monitoring the national average rent from 1970 to 2021 is also displayed. The year 1980 stands out as the year when rent levels experienced a significant uptick, coinciding with record-high inflation.
Another chart provides insights into the annual rental price growth, which in 1980 saw an increase of 11.98%. This period in the 1970s and 1980s witnessed rental costs ascending in tandem with the inflation rate.
S&P 500 & The Stock Market
Businesses that often fare best during periods of inflation typically operate with minimal capital investment. Notably, the S&P 500 index encompasses a diverse array of technology companies and communications services. A significant limitation of this index is its tendency to allocate higher weights to larger corporations that dominate the market.
The index tends to underrepresent smaller entities that might yield higher returns over the long term. While similar investment opportunities are available, they might face challenges when included in such an index. The SPDR S&P 500 ETF Trust (SPY) serves as a benchmark for the 500 largest publicly traded companies in the U.S. It boasts a net asset portfolio of $252 billion and maintains a low expense ratio of 0.0945%.
Frequently Asked Questions About If Real Estate is a Hedge Against Inflation
What should I invest in during hyperinflation?
During periods of hyperinflation, it is prudent to invest in multifamily real estate featuring high occupancy rates. These properties are less likely to depreciate significantly, providing a reliable income stream in a form that remains liquid, enabling conversion to cash as needed.
What is the best way to hedge against inflation?
The optimal strategy for inflation hedging involves investing in multifamily real estate. As living costs rise, renters may face increased expenses, yet landlords benefit by adjusting rents upward due to established long-term leases with dependable tenants. This approach not only secures steady income but also fosters wealth accumulation through consistent returns.
Is it good to own real estate during inflation?
Yes, owning real estate during inflation is advantageous. Properties generally appreciate in value under inflationary pressures, offering greater potential returns than traditional banking investments. While rental values are stable, the rent charged can fluctuate with inflation, leading to higher revenue. This scenario often results in lower relative expenses, as many prefer purchasing in downturns with the prospect of selling when the market thrives. Real estate investments typically exhibit one of the highest risk/return ratios, providing landlords with superior purchasing power and stable financial performance, outpacing other investment types during intense inflation.
Is Real Estate a Hedge Against Inflation – Conclusion
Private real estate investments offer substantial risk-adjusted returns, making them a formidable choice for those seeking an inflation-resistant investment solution. These investments come equipped with all the advantageous tax benefits of direct ownership. Hard assets, such as multifamily real estate, excel in this arena due to their inherent value, potential for appreciation, rising income through increased rents, and the natural depreciation of debt. It is crucial to factor in inflation when assessing potential investment opportunities.
Investment strategies such as solid core, core plus, value-add, and opportunistic investing in private real estate have consistently demonstrated reliability and growth over time. These methods not only safeguard against inflation but also offer a buffer against market downturns. Moreover, private real estate investing generates passive income streams, allowing investors to maintain cash flow while diversifying their financial portfolio in other sectors. This approach is one among many that can fortify your investments against inflation.
And keep in mind, due to the impact of inflation, a dollar today indeed holds more value than a dollar tomorrow!
