You know how everything cost less when we were younger? I remember getting a snack after school as a kid, when a Snickers bar was 35 cents and a can of Coke was 50 cents. Now they’re roughly three to five times that much. Despite that story showing my age, it also demonstrates the concept of inflation.
Inflation is defined as a general increase in prices and fall in the purchasing value of money. In a nutshell, inflation means that the prices of essential goods and services are rising faster than our income is.
Unfortunately, in the U.S., we’re currently experiencing record high inflation, the highest we’ve seen in 40 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 this 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, and 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. While prices will eventually even out, even then, owners can expect 6 to 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; however, the monthly payment never changes. Meanwhile, inflationary pressures have driven rents on single family homes steadily upward over the last year or two. Apartment List reported that year-over-year national rent growth from August 2021 to 2022 was 10%, down from 18% between 1Q 2021 and 1Q 2022.
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, and 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 can’t 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 mortgage 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’ rental income, you ultimately come out ahead.
The price of commercial real estate 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 currently at an all time high in the U.S., 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 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 from bonds and mutual funds during inflationary periods.
Related Article: Stocks vs. Real Estate: The 4 Risks to Know Before You Invest
Building Wealth in a Poor Financial Climate
The sustainability of real estate investing is one of the top reasons investors are flocking to real estate, particularly during periods of inflation. 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 rise in equity. And many people are turning their equity into debt by implementing cash-out refinances.
While the general population is wishing or hoping for some type of hedge of protection against the inflation we’re experiencing, 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.
Bottom line – while you can’t wish inflation away, you can learn how to benefit from it. Don’t just wish your Snickers and Coke were cheaper…invest in something (like debt-leveraged real estate) that helps your wealth growth outpace inflation so you don’t have to worry about prices.
Further Reading: 5 Reasons Real Estate is the Most Effective and Lucrative Investment