Commercial real estate investments are an excellent way to diversify one’s real estate portfolio. However, multiple COVID-19 stimulus packages, staggering money supply, and fiscal budget deficits have led experts to predict higher-than-normal rates of inflation in the long run. Nevertheless, historical trends have shown that multifamily real estate investments have had a positive correlation with market volatility and inflation. Reports suggest that in the inflationary periods between the 1970s and early 1980s, multifamily real estate outperformed other commercial real estate sectors.
Hence, they retained their resilience even amidst tremendous market volatility. Therefore, in this article, we will discuss how multifamily real estate investments will provide a hedge against inflation.
What is Inflation?
Inflation is the general rise in the price level of goods and services in an economy over a period of time. Inflation occurs when the prices of necessary goods and services rise. These include food, clothing, and housing. When the demand is more than the supply or when an increase in production costs decreases the supply, consumers are disposed to pay more for these necessary items. Thus, these scenarios induce ‘demand-pull inflation’ and ‘cost-push inflation’ respectively.
In the United States, inflation has been fixed at 1.4% since the great recession. However, the federal reserve which regulates the country’s monetary policy has historically set the benchmark for annual inflation at 2%. The Federal Reserve uses Consumer Price Index (CPI) to measure inflation. The CPI rose by 0.8% in April after its 0.6 % rise in March. Therefore, the CPI climbed 4.2 % since April 2020.
Moreover, Bloomberg’s economic survey predicts that inflation will rise above 3% from Q2 2021 through the end of the year. This is largely due to the economic distress caused by the COVID-19 pandemic. As a result, the Fed allowed inflation to exceed the traditional 2% baseline.
The Fed states that low to moderate inflation levels bolster the economy. According to the Federal Reserve, it allows households and businesses “to make sound decisions regarding saving borrowing and investment which contributes to a well-functioning economy.”
However, the question remains how can commercial real estate investors mitigate the risks of losses within their portfolios during inflation? It’s a lucrative scenario for multifamily real estate investors. They can maximize their returns and profits even amidst an inflationary environment that is derivative of post-pandemic economic recovery.
How can multifamily real estate assets be a hedge against inflation?
During periods of rising inflation, interest rates for mortgages increase. Therefore, homebuyers lose their purchasing power and thus prefer multifamily rentals over homeownership.
In such cases of surging demand, multifamily investors hike up the rents of the multifamily units.
Furthermore, multifamily real estate assets have short-term lease agreements with leases expiring constantly. The leases are typically structured with six to twelve-month terms.
Therefore, the higher turnover rates of leases allow multifamily operators to adjust the average rents periodically on the lease expiration dates.
As a result, flexible lease agreements enable them to keep up with the inflation-induced changing market rates. This is in sharp contrast to other commercial real estate assets that have longer lease durations. As a result, they must weather the inflationary impacts.
The American Housing Survey shows that during the periods of average inflation in 1973-1983, the median rent expanded at an average annual rate of 8.5%. It is noteworthy that such rental rises surpassed the standards of inflation.
When securing a loan to invest in commercial real estate, investors can utilize long-term, fixed-rate loan structures. Hence, low-interest loans in fixed rates allow multifamily investors to pay lower mortgage repayments during inflation. Therefore, fixed-debt payments amidst a flourishing rental and capital appreciation prove advantageous to multifamily investors.
Net operating income (NOI)
By increasing the rents, Multifamily real estate investors can also boost the Net Operating Income (NOI) of their assets. Net operating income is the gross revenue of an asset from rents, fees, and other ancillary income minus its operating expenses.
During periods of inflation, a multifamily investor must ensure that their income flow from the property exceeds its expenses. Therefore, to keep pace with the inflation rate, a multifamily investor must increase the rent to a moderate level.
Furthermore, investors must focus on superior property management in a multifamily asset. For instance, refurbishing the units, installing cost-efficient amenities and better lease terms lead to value appreciation. Thus, multifamily landlords can renegotiate rental rates with the tenants by providing them quality living experience.
Therefore, an older multifamily asset accommodating modern facilities and better property management will rationalize a fair increase in rents. On the other hand, the demand for these multi-family real estate assets will continue to be on the rise with new or existing tenants not minding paying a little extra for the additional amenities and comfort. As a result, multifamily real estate investors can position their assets to stabilize and provide excellent cash flow thereby cushioning the effects of inflation.
Multifamily real estate value appreciation
Appreciation of an investment is the only way for investors to make money in real estate. As mentioned earlier, multifamily assets with short-term leases and rental flexibility provide the best hedge against inflation.
During an inflationary period, as the prices of goods and services go up, so do the wages. Therefore, multifamily real estate operators can expect to augment their Capital appreciation with rental swellings.
As real estate has intrinsic value, even with higher rents that align with the pace of inflation, a multifamily asset in key areas will continue to attract tenants. Moreover, inflation increases the costs of new construction and labor and also the borrowing cost of debt.
Therefore, this limits the development of competitive housing units in adjoining areas. Hence, the values of the existing multifamily real estate assets increase, thereby justifying the rental hikes.
The value appreciation of a multifamily asset occurs when the tenants pay higher rents with their rising wages and profits. Such rental growth and a lack of competitive housing units in the nearby areas lead to multifamily property value appreciation. As a result, multifamily investors experience greater value appreciation. This is largely due to an increased demand for their existing assets in the absence of newer structures.
In this figure, the average annual growth rate of multifamily assets is seen to double the annual rate of inflation in the US. Therefore, multifamily real estate investors can breathe a sigh of relief. It is historically proven to perform well in inflationary environments.
Multifamily real estate- the stable bulwark against inflation
Although inflation erodes the value of the currency and the purchasing power of homebuyers, multifamily assets are inherently well-arrayed to be a hedge against inflation.
With its ability to enhance the value of its assets through an upsurge in its rents and net operating income, multifamily real estate outpaces inflation. Furthermore, investors can benefit from fixed-rate mortgages that stabilize their income flow.
Post-pandemic, It is likely that the Fed will allow inflation to grow with low-interest rates. However, multifamily real estate investors can particularly prosper during inflation and continue to diversify their portfolios with various investment vehicles like crowdfunding and REITs.