Real estate has a long history of being seen as an inflation hedge due to its unusual combination of rising income, appreciating value, and decreasing debt, which allows it to keep up with rising expenses.
What makes real estate such an effective inflation hedge?
- Inflation is defined as an increase in price over a period of time, such as rising housing or rent prices.
- Excess money supply, supply and demand shocks, and the public belief that prices would rise are all common drivers of inflation.
- Investors use real estate as an inflation hedge by taking advantage of low mortgage interest rates, passing on growing costs to renters in the form of higher rents, and profiting from rising home values over time.
How may real estate be used as an inflation hedge?
While inflation will reduce the net returns of bonds, stocks, and fixed-rate vehicles, real estate managers can lessen the effect of inflation by raising rents at managed properties. Naturally, this does not happen in all properties, property kinds, or markets. Have you ever had a landlord who seemed completely immune to the forces of inflation, leaving you with a ridiculously low rent? In order to properly combat inflation, forethought is required.
Here are a few strategies used by commercial real estate investors to reduce the risk of rising inflation:
- Rent increases are contractually tethered to higher fluctuations in the CPI through CPI indexation. While this may appear unnecessarily bureaucratic, throughout the 1970s and 1980s, when inflation was more rampant, it was fairly standard.
- Rent reviews that are built into leases on a regular basis. This is especially significant with longer-term agreements and/or when the property has few or only one tenant.
- Sponsors may be able to move part of the costs of renovating and managing a property to tenants by shifting operating and capital improvement expenditures to renters. Materials, services, and utilities, in particular, are likely to follow inflation. While this trend may necessitate lower gross rents in order to remain competitive in the leasing market, it can have a significant impact on net operating income (NOI) over the course of lengthier leases. This is true for non-residential CRE asset classes such as industrial, retail, and office.
The basic line is that we believe real estate can serve as a reliable inflation hedge, but only if it is properly managed. As a passive real estate investor, you might want to inquire if the sponsor has a plan in place to keep NOI growing at a rate that keeps up with inflation so that returns aren’t diluted over time.
Does inflation boost real estate?
Real estate prices rise in tandem with inflation as the cost of living rises. In general, when inflation rises, housing and other real estate asset prices rise with it. However, because mortgage rates are rising, this tends to exert downward pressure on real estate demand as debt becomes more expensive.
Does real estate provide inflation protection?
Real estate prices and rents not only tend to keep up with inflation, but they also fuel it. As a result, they frequently increase at a quicker rate than the official CPI inflation index.
According to the Federal Reserve, the median US home price in the third quarter of 1991 was $120,000. Despite inflation accounting for only a part of the increase, home prices in the third quarter of 2021 reached a median value of $404,700, more than three times more than in 1991.
Because, well, real estate is real. It’s a tangible asset with inherent value. People need and seek money regardless of the currency, and they change their offers to buy or rent it as needed to secure it. As a result, it is one of the most reliable inflation hedges.
What exactly is an inflation hedge?
- Inflation hedges are investments that safeguard investors from the depreciation of their money as a result of inflation.
- During inflationary cycles, the investments are expected to preserve or increase in value.
- Inflation hedging is a strategy used by investors to maintain the value of their investments while keeping operating costs low.
Is inflation beneficial to real estate investors?
I admit that I’m old enough to recall the 1970s flares, discos, and collars.
But not just the modest 2 or 3 percent inflation of the previous year, but true double-digit inflation, the kind that saw the price of a Marathon go from 2 pence to 2 and a half pence overnight. Indeed, following the 1973 oil shock, when the price of oil tripled (are there any parallels here with our current economic woes?) For the rest of the decade, inflation stayed in double digits, peaking at 24 percent in 1975.
The Consumer Price Index is now rising at 3.3 percent (1.3 percent higher than the official objective of 2%), while the Retail Price Index (excluding mortgage interest payments) is rising at 4.4 percent (not far off 2 percent above its old 2.5 percent target).
However, most of us believe that these data understate the true situation. Majestic, the wine retailer, said that wine prices would have to climb by 10% to meet transportation expenses and the increasing euro, and that banana prices would rise by 8%.
The majority of this inflation comes from outside the country, in the form of increased gasoline and food prices. Twelve of the 55 countries surveyed by the Economist have double-digit inflation rates.
Inflation, according to most economists, is bad for economies. Consider what is happening in Zimbabwe, when buying a loaf of bread from the local market requires a barrow load of cash. Consumers and businesses find it difficult, if not impossible, to make economic decisions due to the lack of pricing stability.
Landlords, like all consumers, are affected by growing costs and prices. Landlords have been hit hard by enormous labor price inflation in recent years, as skill shortages have driven up the cost of hiring all trades, including plumbers, builders, and decorators.
Other expenses, such as accounting and buy-to-let insurance, are also rising.
The one huge benefit of inflation for landlords is that, because many landlords use a buy-to-let mortgage to fund an investment, their loan charges are the most expensive part of their rental company. Inflation, on the other hand, is excellent news for borrowers like landlords, and here’s why.
If a landlord takes out a 100,000 interest-only buy-to-let loan over 20 years in a zero-inflation country like Japan, that buy-to-let mortgage will still be worth 100,000 after 20 years. Consider the case when inflation is running at the Bank of England’s current target rate of 2%. This means that the buy-to-let loan’s true real value will have decreased to 67,297 after 20 years.
Consider a scenario in which inflation is twice the Bank of England’s target rate, with a long-term average of 4%. In this case, the loan’s real value drops to 45,639, which is less than half of its original value.
As a result of declining property values and rising buy-to-let loan costs, being a landlord may not seem like a great place to be. Inflation, on the other hand, may be just what landlords need to reduce the real value of their buy-to-let loans. There is a silver lining to every dismal sky, as the clich goes. In this scenario, inflation may very well be the culprit!
Inflation favours whom?
- Inflation is defined as an increase in the price of goods and services that results in a decrease in the buying power of money.
- Depending on the conditions, inflation might benefit both borrowers and lenders.
- Prices can be directly affected by the money supply; prices may rise as the money supply rises, assuming no change in economic activity.
- Borrowers gain from inflation because they may repay lenders with money that is worth less than it was when they borrowed it.
- When prices rise as a result of inflation, demand for borrowing rises, resulting in higher interest rates, which benefit lenders.
Is real estate a good inflation hedge?
The loss of purchasing power as a result of inflation is possibly the most noticeable element of rising prices for individuals. In anticipation of these rises, wise investors look for measures to protect themselves from inflation.
Investing in an asset that is predicted to sustain or increase in value during an inflationary time is known as an inflation hedge. Hopefully, it will appreciate faster than, or at least on level with, inflation. Rent and property values tend to rise with inflation, hence real estate has long been thought to be a good inflation hedge. Real estate and farms have been shown to be excellent inflation hedges in the past.
I compared inflation to the new home price index and farmland values from 2000 to 2020 to see how effective real estate and farmland have historically been as investment hedges in Canada.
Because it is the most timely indicator of changes in residential real estate values, I chose the new home price index as a proxy for property appreciation. The appreciation was calculated using farmland values received from Farm Credit Canada.
The cumulative inflation change from 2000 to 2020 was 39%, compared to a change and growth of 51.8 percent in the new house price index. The new price housing index tracked above inflation, according to the data.
Between 2000 and 2020, the value of farmland increased by 168.4 percent. According to the data, Canadian farmland has surpassed inflation by a wide margin.
Residential real estate and farmland values both increased faster than inflation over this 20-year period, implying that both were effective inflation hedges.
In a hyperinflationary environment, what happens to real estate?
What happens to property in a hyperinflationary environment? The cost of your down payment does not affect the price of your home; it is determined by the rate of inflation multiplied by the cost of the home. Inflation may have quadrupled the value of your down payment if the house’s worth doubled.
What happens to property when prices rise?
Prices are rising all around the world. The most recent official inflation estimate in the United States shows that price increases have reached a 31-year high1. It’s reaching 29-year highs in Germany2. Inflation in Canada recently hit an 18-year high3, while price rises in the United Kingdom are at a ten-year high4.
In Australia, inflation has been far more subdued, with the headline rate increasing 3% in the year to September quarter5. The Reserve Bank’s preferred gauge of inflation, underlying inflation, is slightly lower at just over 2%6. However, prices are higher than they’ve been in previous years, and experts are split on how long they’ll stay higher.
Real asset investors must consider the ramifications of the recent surge in inflation as the global economy rapidly returns to recovery mode.
Real assets have historically outperformed other asset classes during inflationary periods, and they’re well positioned to help investors weather the current inflationary storm. There are a number of compelling reasons for this.
- In most cases, the income from real assets is tied to inflation. As prices rise, income rises as well.
- Real assets, such as real estate and infrastructure, tend to do well during economic upswings as demand rises, rents rise, and utilisation improves.
- Real asset returns have historically outperformed other sectors amid inflationary surges over the long run.