David is the Founder and CEO of Realized, a firm whose mission is to improve lives through innovative investment property wealth solutions.
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The headlines these days are worrying — inflation is the highest it’s been in over a decade, the situation is volatile and the future is uncertain. But what’s the real story? Why is inflation such a concern now, and how can you protect yourself against its negative effects?
Like many other areas of our lives that have been anything but normal over the past year, we can blame this spike in inflation on Covid-19 or, more specifically, our light-speed return to normal life. We’re traveling and heading back to work. Restaurants are open. And the large federal economic stimulus plans, combined with the $2 trillion we’ve collectively saved over the past year, have us spending like, well, like we’ve been on lockdown for a year.
An economy that’s coming back to life is fantastic news. But what concerns economists is the potential fallout. If we party like it’s the roaring 20s, spending too much too fast could lead to an oversupply of demand, which in turn could lead to big-time inflation.
What caused this record inflation increase?
Have you ever heard someone lament over how it used to cost $5 for two movie tickets and popcorn? They’re talking about inflation — the rise in prices for goods and services over time.
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It’s a naturally occurring economic event that, for the most part, rises in a slow but steady incline. In the face of a disaster like a global pandemic, that steady incline can become a mountain. The latest report from the U.S. Bureau of Labor Statistics shows that the Consumer Price Index (CPI), a measure of inflation, has gone up 5% over the past year. That’s the highest increase since 2008 — which, not by coincidence, was the last time the country was in a different kind of financial crisis.
It’s the result of a number of seemingly competing factors. On the upside, the unemployment rate is down to 5.2% (versus 11.2% in June 2020), and Americans are sitting on an extra $2 trillion that they’ve saved over the past year. Conversely, however, manufacturers and retailers are reporting shortages in everything from diapers to chicken wings, and it costs up to $700 a day to rent a car in some markets.
Altogether, it paints a picture of a fast-moving and volatile economy that’s heavy on demand, short on supply and underpinned by one big question: How long will this inflation last?
One way to make sure the answer doesn’t have a negative impact on your portfolio is to include assets that are considered hedges. Simply put, a hedge is a “just in case” — something that usually moves in opposition to the market, or isn’t subject to wild fluctuations. Hedging is considered part of a diversified portfolio because it can potentially help minimize losses if the market takes big swings in reaction to events like inflation.
A number of assets are often touted as good bets against inflation, including some types of bonds, gold, other commodities and real estate.
How To Use Real Estate As A Hedge
Real estate also makes the list for a number of reasons. First: the effect of inflation on debt. As a home price rises over time, it lowers the loan-to-value of any mortgage debt, acting as a natural discount. As a result, the equity on the property increases, but your fixed-rate mortgage payments remain the same.
Inflation also benefits real estate investors who are earning income from their rental properties, specifically property sectors with short-term lease structures like multi-family properties, because higher home prices often equal higher rent. If you’re able to adjust your rent up while keeping your mortgage the same, this can create the opportunity for increased money in your pocket.
Finally, real estate can be a good hedge against inflation because property values over time tend to stay on a steady upward curve. Most of the homes that hit rock bottom when the real estate bubble burst in 2008 were back to their pre-crash prices in less than a decade. Real estate investments can also provide potential recurring income for investors and can keep pace or exceed inflation in terms of appreciation.
One way to use real estate to hedge against inflation is to invest in a multi-family property. Unlike some commercial properties like retail shops or restaurants, which usually have multi-year business leases, individual rental units usually renew leases every year. The more units a building has, the more frequently you’re presented with opportunities to adjust the rent.
In addition, multi-family properties like apartment complexes are a unique asset class in that they are always in demand (especially when housing prices go up), but also see a relatively high turnover rate at 47.5%. Plus, due to the increase in labor and material costs, there can be a limited supply of buildings or new development projects, which can create an increase in rental rates and property values. Together, these two factors equal a property that will likely not be vacant for long stretches of time and multiple opportunities to renew or start leases at market-adjusted rates.
An additional point to consider is that expense reimbursements, another lease component, is another way real estate is able to pace inflation. Leases pass some form of a property’s operating expenses down to their tenants, regardless of the type of building structure. For example, with a triple net lease property, the tenant is responsible for 100% of property-related expenses. As utility and maintenance fees rise with inflation, landlords and owners may be partially insulated from the effects on the property’s cash flow.
There are some aspects of inflation that we just can’t avoid, from higher prices on consumer goods to an increase in interest rates. The good news, however, is that even if the predictions become reality, real estate is one way to shield yourself from some of inflation’s other effects.
Full disclosure. The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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