Economists define inflation as the slow and silent killer of wealth or value of currency over a period of time. Inflation is an economic phenomenon that involves steady and sustained growth in the prices of goods and services. Obviously, this is something that nobody wants as it eats up their wealth. Thankfully investing in real estate is a way that has proven to be a hedge against inflation.
Previously investors did not pay much attention to inflation risk as the rate of inflation was nominal. In the past two years, the pandemic has temporarily closed businesses, disrupted supply chains, and resulted in an economic collapse. The aftermath saw a major decline in the purchasing power of money as prices increased at an alarming rate. Over the past year, inflation in the United States has risen by 5.4 %, while GDP grew by 4.9%.
To safeguard against this inevitable decay of purchasing power, investors seek assets that hedge against inflation.
Inflation and real estate: Effects of inflation?
Inflation has been a cause for worry among investors for the past couple of months. With the pandemic still not over, the economic condition is yet to be normal. As of October 2021, the U.S. Consumer Price Index (CPI) rate increased to an all-time high in 30 years to 6.2%.
However historical events have proven that inflation has always sparked an increase in rental rents, and property prices. In the 43-year history of the NCREIF Property Index, private real estate returns have always been strong during inflation. In Q3 2021, the NCREIF returned a strong annual rate of 12.1% while the inflation rate was 5.4%.
Unlike other market sectors, real estate investors hardly feel any adverse effect of inflation. Since their investment is pretty well hedged against inflation. Here’s how the prices rising with inflation affect the housing markets.
Value of Property
As discussed earlier, the prices of commodities and basically everything increases due to inflation. Real estate prices are no exception in such scenarios. With the increased cost of construction materials and services, the cost of building properties increases too. This eventually leads to an increase in the price of new real estate properties.
Investors determine a good deal by comparing the asset’s price to its replacement cost when purchasing an existing property. For example, the cost of constructing a new apartment may be more than the purchase cost of an existing apartment. Therefore, it is obvious the buyer would prefer purchasing an existing building to constructing a new one. Rising construction costs will also result in higher prices for existing buildings.
Increase in Rental Rate
As the general price of everything increases so does the mortgage rate. As a result, more people are inclined towards renting rather than buying properties. This increase in demand for rental properties leads to owners raising the rental rates. The high rental and low vacancy rates help landlords and investors to get huge returns. This helps investors with a fixed mortgage rate pay off their loans quickly and easily.
Real estate appreciation
It is a highly efficient strategy to hedge against inflation. For more than a decade, the real estate appreciation rate in the United States has consistently exceeded inflation. Although appreciation doesn’t return high gains, it definitely helps in protecting against inflation.
Decrease in debt value
As we’ve discussed earlier, inflation causes the value of a currency to decline over time. For example value of $100 at present is greater than the value of $100 in the future. Inflation allows debtors to repay their lenders with money that is worth less today than it did when they borrowed it. As a result, it benefits real estate investors to fight inflation with debt depreciation.
Which investments should you prefer in Real estate as a hedge against inflation?
Residential Rental Properties
People will always need a home regardless of the downfall in the economy due to the pandemic or inflation spikes. Residential real estate properties have a good value for appreciation therefore house prices have always seen a gradual increase over time.
Studies have shown that assets like single-family homes and multi-family apartments have proven to be a good hedge against inflation. Several studies show that housing market returns can be comparable to equity returns over the long run. However, they are less volatile and less affected by business cycles. Hence investors see residential properties as the best hedge against inflation
As we all know investing in hard assets or physical real estate requires substantial capital outlays. Due to this, a lot of real estate investors miss out on some of the best opportunities. This is where Real Estate Investment Trust (REIT) and REIT exchange-traded funds (ETF) come into play.
REITs operate exclusively on income-generating properties by dividing their profits among shareholders through dividends. Investors can buy and sell REIT shares on exchanges much like the Exchange Traded Fund (ETF) shares. Property values and rental income are used to calculate dividends, which helps protect the value of shares from inflation. Hence, REITs offer a reliable fixed-income source and act as a natural inflation hedge.
The portfolio diversification provided by fractional ownership allows you to pick your choice of investment. Also, fractional ownership benefits investors with capital appreciation of the property along with the regular flow of rental income. According to experts, fractional ownership is safer, more stable, and capable of generating steady income in all kinds of economic environments.
Land is a fundamental asset of real estate and being a limited resource its value increases with the ever-increasing population. People will always need a place to build their homes and a place to farm. Although it does not yield very high returns it is a great appreciating asset to fight inflation.
Lending to real estate investors
Lending money secured by real estate provides both strong returns and a hedge against inflation. Crowdfunding platforms help you invest in loans required by real estate investors to fund their projects. This is a perfect method for passive income and hedging against inflation.
How can investors use real estate as a hedge against inflation?
Inflation can be beneficial to real estate investors, from lowering mortgage debt to earning a steady income from rental properties. Generally, mortgages have a fixed rate therefore increase in home prices, results in the lowering of the loan-to-value of the mortgage. Thus inflation acts as a natural discount to mortgage debt.
Rental properties are one of the important assets that safeguard against inflation. Commercial properties like restaurants and retail outlets generally involve long-term leases. While rental units like multi-family apartments have short-term leases that renew every year. Thus giving investors the opportunity to adjust rent frequently.
Expense reimbursement is another way for real estate to keep up with inflation through leasing. Leases like NNN leases help investors transfer some of the operating expenses to the tenants. As a result during the time of inflation, investors are safe from the increased utility and maintenance costs.
The high cost of goods and services, including labor and materials, leads to a shortage of new homes and apartments. This can cause rents and property values to increase. As a result, multi-family property like apartment buildings sees an increase in demand due to inflation. With multiple tenants, it gives investors high returns and steady cash flow.
Despite the fact that inflation erodes your wealth, investors can use inflation to their advantage by investing in inflation-protected assets. There are several ways to do so. For example stocks, US Treasury inflation-protected securities (TIPS), and purchasing commodities like silver and gold.
however, real estate is the only tangible asset that has proven to be a good hedge against inflation. Nobody knows how inflation will play out in the end. For this reason, investors can only protect their assets by acquiring the requisite knowledge and planning in advance.