Is Real Estate Really A Hedge Against Inflation?
Have you ever had that experience where a new Adele song comes out and it seems to be everywhere? It’s on at the grocery store, you hear it on the radio driving, or it’s the song that plays in the gym. (I mean…who listens to Adele while working out?!)
That’s how talk about inflation is these days―it’s all over the place! It seems like 50% of the articles, videos, and podcasts that pop up on my feeds are related to the topic in some way.
As investors, we don’t just listen to information. We ask how this information is relevant to our personal investment strategy and where we may need to adjust.
Now, you have probably heard that real estate can be a tool to hedge inflation, but is that really the case? If so, how does that work? To cut to the chase, indeed, real estate can serve as a strong hedge against inflation―and for sometimes unexpected reasons.
In this article, let’s put a spotlight on three powerful ways real estate investment provides benefits against inflation.
What is inflation really?
Before exploring the reasons why real estate is a great hedge against inflation, let’s first take a look at what inflation is.
I appreciate the simple definition Peter Schiff uses: Inflation is an increase in the money supply. This increase results in the eroding of the value of our currency.
The reported inflation as of November 2021 is about 6.8% annually. This number is based on the Consumer Price Index. The topic of how accurately CPI measures true inflation is hotly debated, and many experts estimate the real number to be higher. But let’s go with 6.8% for now. This means, at 6.8% inflation, your $100 one year ago now has only a purchasing power of about $93 today. Why does this happen?
Here’s a simple illustration of how inflation works. Imagine you are playing Monopoly. What will happen if the money supply within the game suddenly increases by 40% but the supply of assets remains the same?
The result will be an increase in the price of those assets. Why? Because now, there is an additional 40% of money going after the same asset supply. Hence, for you to be able to buy an asset, you will have to pay a higher price than its value before the 40% money supply increase took place.
Simply put, after inflation, your dollar loses a portion of its purchasing power.
Since 40% of every dollar in circulation has been created in the last two years, an inflationary environment is likely to continue. At the current rate, if you are an employee who does not receive a 6.8% raise each year, you are earning less. If your dollars are not producing more than 6.8% in returns, you are losing value.
The Federal Reserve claims that inflation is expected to be “transitory.” But let’s be clear about what that doesn’t mean. It doesn’t mean that prices go backward.
For example, the Case Schiller Home Price Index is up 20% year over year. It will not likely continue at that rate forever. But it doesn’t mean that home prices will go down to where they were either.
In my view, the more accurate way to describe inflation is that its current rate may be transitory. Once things go up in price, they tend to stay there. And, at some point, the price may continue to increase but at a rate lower than previously.
Why is real estate a strong hedge against inflation?
Here are three key reasons why real estate is a strong hedge against inflation:
1. Price inflation
Price inflation is the increase in the price of a standardized good or service over a specific period of time.
How does price inflation affect real estate?
Let’s say you buy a property for $1 million, and inflation maintains a rate of 5% per year (for simple math). That means after two years, your property’s value increases to $1.1 million. You gained $100,000 in equity before you count any pay-down on the loan you made to purchase the property.
We’ll assume you are a wise investor and put a safe amount of debt on this property. You put 25% down and borrowed 75%. This means you are all in for $250,000.
Over two years, you have gained an additional $100,000 in equity. That’s a 40% return in two years―and that’s just your equity. Cash flow you receive along the way has yet to be counted. You gained $100,000 in equity by leveraging the lender’s money.
2. Debt Debasement
Debasement refers to the lowering value of the currency.
This is very powerful right now because debt is rarely cheap while inflation is high.
Let’s say you borrow $1 million to purchase a property, and inflation is at 5%. After a year, the current value/purchasing power of the $1 million you borrowed is $950,000. After two years, it is the equivalent of $900,000 because the currency continues to drop in value.
This lowered value isn’t because of the loan pay-down. It’s because you are borrowing the dollars “at today’s value.” The value is locked in at the dollar’s market price at the beginning of the loan. Therefore, the value of what you owe continues to decrease year after year!
Are you seeing this? Even when you factor in the interest, the current interest rates are so low; less than the rate of inflation, it makes your debt even more attractive.
3. Cash flow enhancement
Cash flow is the lifeblood of any business. So how can cash flow be enhanced as a result of inflation?
In an inflationary environment, the cost of goods and services increases in such a way that buying the same amount of stuff would require more dollars than it used to.
The cost of housing and rent also increases. In fact, rent often outpaces inflation. The current national estimate for year-over-year rent increases is over 12%, while inflation is estimated to be around 6.2%. Some markets have seen rent increases of over 20%.
When you own an apartment building, several expenses are subject to inflation. Examples of these expenses are payroll/labor, cost of materials, cost of utilities, insurance, taxes, and so forth. But do you know what the biggest expense is? That would be DEBT―the payment on the loan.So now, even when your rent is increasing at or above the pace of inflation, your biggest expense (the debt payment) stays the same.
Now THAT’S a cool deal!
Conclusion
We can talk all day about what causes inflation, whether it is a good or bad thing, and what should be done about it. But the bottom line is that inflation is here.
Yes, inflation has an impact on consumers. It has a particularly significant impact on the middle class that relies on W-2 income which may not be increasing at the same rate as inflation.
But since inflation is here, shouldn’t we be investing in assets that actually benefit from inflation?
I think you know where I stand on that.