Investing in real estate can be an excellent way to diversify a portfolio as pricing of real estate is relatively uncorrelated to the stock market, and it doesn’t experience daily price fluctuations often driven by investor sentiment given its illiquid properties. In addition to protecting investors from volatility, real estate can also act as a hedge against inflation.
Inflation is, in broad terms, the rise in prices for goods and services over time. This leads to the decrease of purchasing power as the same currency affords less goods or services. A moderate rise in inflation is generally regarded as a positive factor for an economy because it encourages consumer spending since people typically want to spend before prices get higher, which can boost businesses, create jobs and ultimately may increase economic growth. But too much inflation over a long period, can have devastating effects on an economy.
In this article we’ll explain what causes inflation, how it affects multifamily investments and why real estate is considered to be a hedge against inflation.
What Causes Inflation and How Is it Managed?
Inflation can be caused when demand outweighs supply or when supply is decreased because production costs were pushed up. The former is known as “demand-pull inflation” and the latter is “cost-push inflation.” In both scenarios, prices are expected to rise eventually for a broad basket of goods and services. Inflation has been low in the United States since the Great Recession, and currently it’s a mere 1.4% as reduced demand for goods and services from the COVID-19 pandemic continue to weigh on the inflation rate.
The Federal Reserve, which sets the country’s monetary policy and manages inflation, has historically set a goal of 2% annual inflation. According to the Fed, keeping inflation low and stable allows households and businesses “to make sound decisions regarding saving, borrowing, and investment, which contributes to a well-functioning economy.”
However, because of the economic fallout in 2020 caused by the COVID-19 pandemic, the Fed decided to update its policy and let inflation surpass the traditional 2% threshold. This policy could change in the future, but the potential of a rising inflationary environment could have deep significance for multifamily real estate investors as inflation can affect properties in numerous ways.
How Inflation Affects Multifamily Real Estate Investments
One of the main differences between real estate and other investments, such as stocks or bonds, is that real estate is a physical asset with intrinsic value. As a tangible asset, real estate derives value from the actual property and improvements, in addition to its rental potential.
Therefore, multifamily real estate investments can generate returns in the form of income from rents (or other services, like parking or pet fees) and appreciation of value. For multifamily properties, there’s resilient demand to rent — even during times of extreme financial turbulence — as people always need a place to live.
During periods of rising inflation, prices increase for goods and services, and even new homes. The increased costs may create a challenge for those seeking to buy a first home, which could lead to elevated rental demand. As the demand for rental units rise, multifamily operators can increase asking rents. The increased rental income would likely exceed the inflationary growth in building operating costs and expenses. Moreover, higher rental rates, the main revenue stream for properties, could also lead to increased asset values.
Why Multifamily Assets Can Be a Hedge Against Inflation?
Since inflation weakens the purchasing power of a currency, the value of fixed returns, such as bond yields, are reduced. Therefore, to hedge against the impacts of inflation, investors typically seek assets that have the ability to grow in value, such as multifamily real estate.
During an inflationary period, although the purchasing power of the currency falls and more dollars may be required to pay for expenses, multifamily rents often rise as well.
The increase in revenue from rents (and possibly other sources of income at a property) may help multifamily investments outpace the increase in prices of other goods and services from inflation. Additionally, the appreciation of multifamily values is another factor that helps fend off the erosion of currency value from inflation. Finally, debt secured by real estate is often in the form of long-term, fixed-rate loans, which keep debt payments stable in periods of rising inflation. Having fixed debt payments while rents and property values grow has the potential to be very advantageous for investors.
Inflation is the rise in prices of goods and services, and it leads to a decrease in the value of currency. This could erode the purchasing power of investors’ money. However, real estate investments can be a hedge against inflation. During inflationary periods, multifamily rents tend to rise and property values appreciate, outpacing inflation, while fixed loans simultaneously keep debt payments stable. With its current plan to keep interest rates low, the Fed is determined to let inflation rise. This may bode well for multifamily real estate investments, and is a strong reason why investors may want to consider adding investments, such as those offered via real estate crowdfunding, to their portfolios.