If you haven’t heard about, read articles on, or had a discussion with fellow investors about inflation lately, I’d encourage you to come out from under your rock more often!
Inflation is the measure of a rise in the cost of living and it’s become a significant concern over the past year. The consumer price index (CPI) is a statistic that measures changes in the prices of a variety of items and services.
When prices for goods and services increase, the purchasing power of each dollar decreases. As an example, your $100 basket of groceries may now cost $120 or more, and the effects of inflation aren’t just seen in consumer goods. They’re seen in property prices, gold prices, individual stocks, and more. When consumers face rising prices on goods and services they typically purchase as part of their everyday life, they’re forced to either earn more or purchase less.
This is tough to understand for many because while the $100 dollar bill may have a face value of $100, its intrinsic value is much less – maybe $80 or $90, which you can feel most tangibly at the supermarket or grocery store.
This can be a particular concern for those investing in stocks, as stock prices may not always keep pace with inflation. One way to create a hedge against inflation and reduce your concerns about the inflation rate is to ensure your investment portfolio contains commercial properties.
Commercial real estate syndications are a great way to passively invest your capital and protect your finances against inflation. In this article, we’ll explore how and why real estate is generally considered an “inflation-proof” investment and what you can do as inflation hits.
How Do Real Estate Investments Protect Investors Against Inflation?
In a nutshell, inflation means that the prices of essential goods and services are rising as your income remains the same. Unfortunately, right now in the U.S., we’re currently experiencing record-high inflation, the highest we’ve seen in 30 years.
But there’s good news, one thing that remains certain in these uncertain times is that commercial real estate is an inflation hedge. So, you’re in the right place, score!
Rent prices have increased dramatically across the country in recent months, due to a surge in the demand for owned homes. The housing crisis of ‘08 and the subsequent years of under-building left those who rushed to buy a home during the early stages of the Pandemic with very few options. Some paid a premium home price while others settled back into renting.
As the Pandemic has worn on, a lack of available properties has been exacerbated by work stoppages, raw materials shortages, and labor constraints, all of which have kept builders from increasing output to meet demand.
This is all doom and gloom for the average consumer, but kinda rosy for your investment portfolio as your properties appreciate because of the higher rental income. When you own commercial real estate (with almost no specificity to a particular asset class), you earn more money simply because of inflation.
So, while others’ incomes remain the same and inflation puts the squeeze on their budgets, your income and overall net worth increases, nearly at the same rate as inflation. Let’s dive a little deeper into why when others feel like their purchasing power is decreasing, real estate investors have an excellent hedge against inflation.
#1 – Real Estate Prices
Along with everything else, physical asset prices rise with inflation. For owners, this means their property values will appreciate more quickly. In the current financial climate, investors and homeowners are seeing record highs in appreciation. Prices will eventually even out, but even then, experts are saying you can expect 6-9% increases to remain in many markets.
Since commercial real estate is valued based on the rental income collected from the property, rising rent will press the overall value of the asset upward. Inflation protection is said to be “built-in” to commercial rental property for this reason.
#2 – Mortgage Interest Rates
Fixed-rate loan payments don’t change for the entirety of the debt agreement, and nonetheless, over time (even in a seemingly calm economic environment), investors’ equity in the property grows.
During inflationary periods, as (commercial and residential) real estate prices soar, assets appreciate at an increased rate, yet their monthly payment never changes. This works in investors’ favor because while central banks don’t require higher loan payments, those earning rental income tend to see a widening gap between what they earn and what they owe on a monthly basis.
Anyone watching their investor’s portfolio experiencing this phenomenon would likely be inclined to scoop up even more investment properties before interest rates rise, further leaning into the inflation protection power of real estate investments.
Why Inflation And Real Estate Investing Stick Together
In most cases, investors are not only protected from inflation but actually benefit from it.
Rental Income Increases
With most investments, like a mutual fund or stocks, for instance, the value dwindles during an inflationary period because the companies in which you’ve invested are also experiencing a diminishing level of purchasing power.
With real estate, however, home values and rental prices increase during times of inflation. Having a place to live is a necessity, not a luxury. So, even when prices are at an all-time high, people aren’t able to avoid the expense of viable housing.
According to Forbes, the winning hedge against inflation is to tie a cash-flowing investment to a long-term fixed interest rate debt. With a fixed-rate mortgage on your rental properties, inflation raises the rent payments but the interest 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 investment asset 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 investment property then gets an increased rate of appreciation relative to the debt.
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 investment 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’ income, you ultimately come out ahead.
The price of commercial real estate property is partially driven by supply and demand, which can also be viewed as perceived scarcity. This is especially true in metropolitan areas where population growth has created a limited supply of space.
When demand is high but space isn’t readily available, real estate investors benefit, as long as price increases on the assets outpace the rate of inflation. We have an interesting conundrum occurring in the US currently – the population has continued to increase over the past decade while the construction and renovation of real estate assets have decreased.
This has resulted in an all-time high in property scarcity, and those who own income-producing real estate are benefiting greatly from the rise in prices, as well as the increased need for adequate housing.
How Real Estate Compares To Other Investments During Inflation
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 broadly 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 for bonds and exchange-traded funds during inflationary periods.
How To Keep Building Wealth, Even While Inflation Takes Hold
The sustainability of real estate investing is, particularly during periods of inflation, one of the top reasons investors are flocking to real estate. According to Forbes, “real estate has made more ordinary people wealthy than any other investment vehicle.”
While the general population is searching for some type of hedge against inflation, real estate investors are thriving. Investors who understand the advantage of relying on real estate are currently building their wealth at an accelerated speed.
Investing in real estate allows you to use low interest rates to your advantage and continue to build wealth, even during times of inflation.