Grandparents are always a source of wisdom, full of the knowledge that comes with having years of experience on this earth. As a child growing up you may have heard many stories from your grandparents stating that when they were your age a loaf of bread, a bottle of milk, [ fill in the blank] used to only cost 5 cents.
Now prices are multiples higher. When you consider your grandparents’ stories, the $3 price tag that you now pay for your bread, milk etc. seems ridiculous. And we are not even talking about the fancy brands here.
You may have even experienced this increase in price during your own lifetime already. Perhaps it was the costs of one of your favorite snacks as a child, or the amount of chips you get in the bag of chips from the deli. Even though it may not be clear how this price increase happened, it is clear to you that you are getting less for each dollar you have.
Why is this happening? There may be many drivers but one of the main sources is the phenomena called inflation.
What is inflation?
So, what is inflation really? To get technical the dictionary definition of inflation is an economic term that signifies a persistent and substantial rise in the general level of prices related to an increase in the volume of money and resulting in the loss of the value of currency (opposed to deflation).
To define inflation in simple words, inflation is the continued increase in prices of goods and services. Said otherwise, the buying power of the currency decreases over time so you must pay more to get the same amount of goods you previously could buy at a lower price.
Why does inflation occur?
There are many theories about why inflation occurs such as an imbalance in supply and demand of goods and services, increasing costs of materials used to create goods, decreasing unemployment rates, government fiscal and monetary policies, expansion of money supply and the list goes on. While people may disagree on what levers exactly trigger inflation, there is no doubt that inflation does exist.
You can see the reality of inflation out of control in economies such as Zimbabwe and Venezuela that faced hyperinflation. The governments of these countries had to continually create new denominations of currency to keep up with the increasing prices.
While the debate on what causes inflation is an interesting one, we won’t dive too deep into that as we all can agree that inflation exists. We’ll focus more time on how inflation impacts you and your investments.
Who benefits from inflation?
Inflation can benefit investors. As an investor inflation can be your friend or your foe. In simple terms inflation benefits those that have assets which increase in value and fixed value liabilities which decrease in relative cost.
Generally, the wealthy and investors will have more assets that respond favorably during inflation. This can be a source of increasing the wealth gap as those without assets get left out of the appreciation (and related growth in net worth) that comes from inflation. Those without assets will have to spend more to acquire new assets as well as take on new debt.
Who is negatively impacted by inflation?
On the opposite side of the coin those that are negatively impacted by inflation are those with assets that are fixed in value and liabilities that are variable in value.
Generally, the poor and non-investors will have assets that are fixed in value and will lose out on the benefits of inflation. These individuals typically have high amounts of savings or earn fixed wages. As the purchase price of goods rise the amount of buying power of these individuals does not rise in step with inflation making their costs of living higher.
What assets do best during inflation? What is the safest asset to own?
As we just discussed, those that have a lot of savings in cash are often negatively impacted by inflation. If it is not a good idea to keep too much of your assets in cash, you may be wondering what assets should you be owning instead?
If you want to identify what is the best investment for inflation protection, there’s no need to look farther than real estate.
Does real estate protect against inflation?
In short answer, yes. Real estate protects against inflation. Real estate is well known to be an inflation hedge.
You may be asking “what is an inflation hedge?”
A hedge is a financial instrument used for investment purposes to offset potentially undesirable changes in the economics of another investment or a third-party external factor that influences the profitability of your investment. An inflation hedge is an investment vehicle that protects an investor against the impacts of inflation such as the decreasing value of currency.
Scared of inflation? Well don’t be. If you have real estate in your investment portfolio you are well protected.
How does real estate investing protect against inflation?
I never thought you would ask. Real estate provides many avenues to protect investors against inflation. You only need to look at how real estate has performed in previous periods of inflation to see the benefit of holding investments in real estate.
How does real estate perform in inflation?
Real estate performs well during inflationary periods. A 2016 MIT study of NCRIEF (National Council of Real Estate Investment Fiduciaries) data showed that multifamily real estate assets value growth exceeded inflation.
Based on the way real estate investments are made (an income producing asset obtained with the leverage of using debt), real estate is well positioned to benefit investors in time of inflation and protect them from the drawbacks of inflation. We can break down the way’s real estate protects you during times of inflation into 4 categories – revenue, expenses/debt, income/value and control.
What happens to real estate during inflation?
Real estate outperforms during times of inflation when you invest in real estate in the appropriate ways; see below for how real estate reacts to each of the 4 categories of inflation protection.
Impact of inflation on real estate revenue
During inflation real estate revenues are positively impacted as they tend to increase. In times of inflation prices rise and so do wages. As mentioned before, those with variable salaries will benefit the most from this increase in income.
This is great news for real estate investors because renters with more disposable income will be able to afford rent increases in line with inflation. In the case of multifamily real estate and other commercial real estate investments that make revenue from “other income” than just rentals (such as package services, utility reimbursements, parking spaces, storage etc.) there is opportunity to see increase in the revenue from these other income sources as well.
This is great news for real estate investors
Impact of inflation on real estate expenses and debt
Real estate may be negatively impacted due to the rising cost of variable expenses but positively impacted by the decreasing relative costs of fixed expenses and liabilities.
Costs of materials and labor increase during inflation so the cost to keep maintenance staff or purchase materials to do repair and maintenance on investment properties will increase. As we just noted however, revenue is also increased to help offset (or hedge) this increase in expenses.
The other part of the inflation hedge effect that real estate provides comes from the debt leverage that was used to finance the investment property purchase. During inflation the cost of fixed rate debt decreases. When fixed rate debt is used to purchase the property, this liability remains the same despite the decrease in value of currency. This means that if you are paying a fixed amount of $1000 for debt (interest expense and principal repayment) today, this may seem like a lot but after 10 years of inflation the relative cost of that expense will seem cheap.
One huge benefit to the cost of debt for real estate investors comes from the amortization of debt. If you are investing using amortizing debt, part of the debt payments you are making relate to principal repayment. Not only is that fixed rate payment decreasing in relative cost but the amount of the payment that goes toward interest expense decreases and the amount that goes back into your pocket (as principal repayment) is increasing. That means more equity and growth in net worth for you as the investor.
Impact of inflation on real estate income and values
Speaking of net worth – the increase in income and hedged increase in costs are a source of increase in net income and cash flow for the real estate investor. Real estate also tends to rise in value (i.e. appreciation) at the same rate or greater than the rate of inflation.
If you are investing in a growing market it is possible that real estate values will increase each year at multiples of inflation. In the case of commercial assets which are valued based on income, the increasing income would lead to increasing real estate asset values.
Impact of inflation on real estate and control
You may be thinking, increasing revenue is great, decreasing debt costs are great but what happens if expense increased faster than revenue? One of the benefits of real estate is control. In a situation where expenses are increasing, real estate investors can take action to help reduce and manage expenses.
This may be done via cost efficiencies gained using new technology or other strategies, negotiating contracts, transferring costs over to tenants amongst many other expense reduction strategies. Further through forced appreciation investors can increase the income and value of investment properties. These changes would help to maintain net income of the investment property and property values.
The ability to control and change the income of an investment property is an indispensable tool for real estate investors to fight inflation.
The ability to control and change the income of an investment property is an indispensable tool for real estate investors to fight inflation.
As we discussed above you can see the relationship between real estate and inflation; real estate performs the following ways during times of inflations:
Increases in rental revenue.
Increase in other income sources.
Increases in costs of materials and labor.
Decreases in cost of in place fixed rate debt.
Increase in the amount of principal paydown on in place fixed rate debt.
Increase in appreciation and value of real estate assets.
Bonus: Real estate investors can take active roles to help control revenues and expenses and consequentially value of investment properties.
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