What Investors Need to Know About Real Estate and Inflation
By: Tom Brady
With nearly $5 trillion being doled out by the federal government to help families, unemployed workers and struggling businesses cope with a generational economic crisis brought on by a pandemic that struck last spring, the drumbeat of warnings about inflation have grown louder.
All the extra money injected into the economy, coupled with a long run of extremely low interest rates, has pushed stocks to record highs. Many economists believe that as the pandemic is brought under control, there is likely to be a surge in consumer spending. Businesses are expected to respond to the increase in demand by raising prices.
The end result: inflation.
Warnings About Higher Prices Ahead
Lawrence Summers, treasury secretary under President Clinton and director of the National Economic Council under President Obama, wrote in January in the Washington Post that the Biden stimulus plan could “set off inflationary pressures of a kind we have not seen in a generation.”
During an appearance on March 20 on Bloomberg Television's "Wall Street Week," Summers said there is about “one-third chance for significant inflation over the next few years.”
So with stock prices high, and already low bond yields likely to take a hit if inflation does rise, where are investors to turn? Inflation erodes the value of savings over time, and makes goods more expensive and salaries worth less if pay raises do not keep pace. Inflation increases the price of the pie you buy at your local pizzeria, and makes flour more expensive for the pizza maker. In countries like Zimbabwe and Venezuela, bouts of hyperinflation rendered paper currency nearly worthless, and wheelbarrows full of it were needed to buy a bag of rice.
Policy makers have set a target rate for inflation of around two percent, though the Fed’s new strategy is to keep inflation at an “average” of two percent. So it is willing to let inflation rise to three percent, as long there is a period of one percent inflation to balance it out. But an inflation rate of three percent or above means that investors are losing money on any assets that are not earning beyond that, or that their return is essentially zero if they are getting a three percent return.
Real Estate Investment Acts as a Hedge Against Inflation
Mynd Investor Services (Home Union), the data-driven real estate investment arm of Mynd Property Management, recommends real estate as a hedge against inflation since home values and rents typically increase during times of inflation.
While consumer prices has risen just an average of 2.1 percent since the turn of the century, the United States experienced a period of out-of-control inflation in the 1970s, because of a variety of factors: the end of the Bretton Woods global financial-exchange system, oil price shocks set in motion when the oil-producing nations of OPEC proclaimed an embargo in 1973 (pushing up the price of gas 300 percent in a year) and a brief period of price controls.
Annual inflation peaked at 13.5 percent in 1980.
Federal monetary policy experts are fairly confident that they can put a damper on any inflationary pressures.
Treasury Secretary Janet Yellen told MSNBC that fears about the recent $1.9 trillion stimulus package juicing the economy too quickly and spurring inflation are misplaced.
“I really don't think that is going to happen,” Yellen said. “We had a 3.5% unemployment rate before the pandemic and there was no sign of inflation increasing.”
But she added that if inflation did become an issue “there are tools to address that” and policy makers would be monitoring the situation and be prepared to act if necessary.
But it’s impossible to predict the future and just how much demand will rise once the pandemic winds down. If inflation does rear its head, “hard” assets like commodities (gold, silver, etc.) and real estate are considered safe havens because their prices tend to rise along with inflation.
The Benefits of Property Ownership in Inflationary Times
Real estate investments, which usually increase or maintain their value over time, act as a hedge against inflation in three ways: appreciating value, increasing income (rents) and depreciating debt.
These income streams are particularly helpful for folks who are living on retirement savings or a fixed income. If you set up a retirement account in 1991 with a $100,000 a year income in mind, you would need $193,10.66 to keep pace because of the cumulative inflation rate of 93.1 percent in the last 30 years (which has been a period of historically low inflation).
In that same period, home prices rose faster than the inflation rate. According to the U.S. Bureau of Labor Statistics, prices for housing were 105.65% higher in 2021 versus 1991 (a $105,654.57 difference in value).
If you go back to 1967, housing experienced an average inflation rate of 4.14% per year, according to the labor bureau. Here is the breakdown: a house costing $50,000 in the year 1967 would cost $446,150.74 in 2021 to buy a similar home. The overall inflation rate was 3.89% during this same period, so housing costs increased more than the price of other goods. (The return of a portfolio of stocks tracking the S&P 500 in that same period saw a return of 20,938.98%, or 10.41% per year. Investing in the stock market should be part of any asset portfolio, experts say, but real estate is a more stable investment and can serve as an alternative when stock prices are high and inflation looms.)
According to Zillow, property values rise between three and five percent a year. In some markets, those increases are greater, up to six percent or even 10 percent or higher. (Of course, in some depressed Rust Belt cities where factories have closed, like Detroit or Gary, Indiana, home values have fallen.)
Aside from appreciation, real estate investments provide a hedge against inflation through the cash flow generated from tenants. Smart investments in rental properties will not only cover monthly expenses, including the principal loan balance, interest, taxes and insurance, but will also generate some monthly income. Lease renewals or property improvements that allow a landlord to increase rents can pump up monthly cash flow. While payments on a loan generally stay fixed, depending on the terms of the loan, rent increases that reflect the overall consumer price index are a routine practice.
Depreciation Is an Investor’s Steady Friend
Another advantage property ownership offers is depreciating debt since the value of the money owed on the property is actually falling in value with the rate of inflation. If a monthly payment is $1,000 in year one, by year 10 that debt is going to be worth far less. A loan originating in 2011 with a payment of $1,000 would be equivalent to $855.24 in 2021.
Leveraged, or financed real estate deals take advantage of depreciating debt. While the monthly payment is the same, the value of that payment will be less as the years go by. And when it comes time to sell the property, the equity built up over the years as the loan principal is paid down, can make for a nice payday for the owner, especially in areas that have seen an uptick in sale prices.
Inflation, even at the historically low rates of the last couple decades, is inevitable. And one of the most effective hedges against inflation, particularly in a period where it appears there will be a bump in prices and stock prices in many sectors feel overvalued, is to invest in buy-and-hold real estate.