Inflation, or the gradual rise in the price of goods and services over time, recently made its rounds in the headlines of every major business news company. All anybody wanted to talk about was how the U.S.’s historically low inflation rate was finally, and rather dramatically, drawing to a close. Used car prices were reaching record highs, lumber prices were soaring, gas prices seemed to be edging upward, and food costs more than it did before.
There is still some debate over the specific cause of rising prices, but it can no longer be denied that basic goods and services are getting more expensive. Inflation is now impacting the life and livelihood of the average American, and, while it remains true that we have experienced a fortunate and extended period of low inflation, it appears as though all good things do, in fact, come to an end — and now is simply the end of inflation’s record lows.
The implication of high, or rising, inflation costs for investors is that high inflation can impact the value of a future stream of cash flow. For this reason, investors need to achieve returns that are higher than the rate of inflation. This means that now, more than ever, investors should be preparing to adjust their investment strategies moving forward and tactfully plan to hedge against inflation.
In this article, we’ll define inflation, discuss how it can be a headwind for investors, and develop one core idea: that real estate investing is potentially the hedge needed to protect yourself from inflation, as well as the loss of purchasing power that results from it.
What is inflation?
Inflation is the gradual increase in the price of goods and services over time. Inflation is measured by monitoring changes in the Consumer Price Index, which is a basket of commonly purchased goods. The U.S. Federal Reserve is responsible for setting monetary policy, and inflation is almost always one of its primary concerns.
The Federal Reserve generally tries to manage inflation to a certain target (around 2-3% annually), though it does reserve the ability to take action when inflation measures above or below this range.
The latest report from the U.S. Bureau of Labor Statistics shows that the Consumer Price Index (CPI), which is one measure of inflation, has gone up 5% over the past year alone. That’s the highest increase since 2008, which was, uncoincidentally, the last time the country was in a financial crisis.
How can inflation be a headwind for investors?
Inflation can be damaging to investors’ capital because they need to achieve returns that are higher than the rate of inflation.
An example can be used to more forcefully make this point.
If inflation is running at a rate of 3% annually, and an investor keeps her capital in a money market account that pays a fixed rate of interest at 2% annually, she is actually losing 1% of her purchasing power each year — relative to inflation. Over the long term, the investor’s capital is able to purchase less because the cost of goods and services has risen faster than her investment returns.
To avoid a situation like this, investors should consider seeking out inflation hedges or asset classes that are uniquely positioned with the potential to perform well in periods of high inflation.
Real estate investing might be the hedge you need to protect yourself from inflation
As Tiger 21 chairman Michael Sonnenfeldt recently explained on FOX Business’ “Mornings with Maria,” real estate has long been an area of wealth preservation and creation.
He said, “Our members have allocations of assets. Real estate is number one, and it’s not only been 27% of our portfolios for a long time — that’s almost $30 billion of assets across our network — but recently, when we polled our members and said, ‘if inflation is coming back, where do you want to put your assets?’ …Real estate was the number one category, because members felt it was the most durable asset to weather through a secular rise in interest rates and inflation that some believe we’re at the beginning of.” See https://www.foxbusiness.com/money/entrepreneur-calls-real-estate-the-most-durable-long-term-asset
He’s correct. Historically, real estate has been a popular choice as a hedge against inflation, because rising prices tend to increase resale values over time, and also because real estate has the potential to generate rental income. Just as the value of the property rises with inflation, the amount of rent tenants pay typically increases over time as well. These increases let the owner seek to generate income through an investment property and helps them strive to keep pace with the general rise in prices across the entire economy.
But, while it’s good to know that real estate investing has been a good hedge against inflation in the past, it’s also imperative to understand if real estate will continue to be the answer in the current moment as well as in the future. As the economy rebounds, it has become increasingly fast-moving, and that can sometimes make it difficult to nail down accurate predictions.
However, the biggest contributing factor to analyze here is inflation itself. With a recovering economy that is heavy on demand, but short on supply, we have to ask ourselves: how long will this period of 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. A hedge is a “just in case” option — something that historically moves in opposition to the market, or something that has not traditionally been subject to much, if any, fluctuations in worth. Hedging is considered part of a diversified portfolio because it has the potential to radically minimize losses if the market takes big swings in reaction to events like inflation.
A number of asset classes are touted as good hedges against inflation, including some types of bonds, gold, other commodities, and, of course, real estate.
Why is real estate considered a good hedge against inflation?
There are a number of reasons. For one, one could examine the effect of inflation on debt. As a home’s price rises over time, it lowers the loan-to-value of any mortgage debt, acting as a kind of natural discount. As a result, the equity on the property increases, but your fixed-rate mortgage payments remain the same.
Inflation can also potentially benefit real estate investors who earn income from rental properties, specifically property sectors with short-term lease structures, like multifamily housing communities, because higher home prices often equate to higher rent structures. If a real estate investor is able to adjust her/his rent up while keeping the mortgage the same, this creates the opportunity for increased money in the investor’s pocket.
Finally, real estate can potentially be a good hedge against inflation because property values over time tend to remain on a steady upward curve. Most of the homes that hit rock bottom when the real estate bubble burst in 2008 went back to their pre-crash prices in less than a single decade. Real estate investments can also provide potential recurring income for investors and can keep pace or even exceed inflation in terms of appreciation.
Since the evidence appears to be in favor of real estate, and it being an asset class that has historically held its own when faced with rising inflation rates, let’s now turn our attention to a few strategies typically used to attempt to hedge real estate investments against inflation.
How can you potentially use real estate as a hedge?
Possibly one of the best ways to use real estate to hedge against inflation is to invest in a multifamily property. Other types of properties, such as commercial buildings (like retail stores), have their tenants sign multi-year business leases. Multifamily housing usually renew leases individually with each tenant once a year. The more units a building has, the more frequently you’re presented with ample opportunities to adjust the rent. The same is true for self-storage.
In addition, multifamily properties such as apartment complexes are a unique asset class in that they are typically always in demand, especially when housing prices soar. Plus, due to recent increases in labor and material costs, there is a limited supply of buildings or new development projects, which can create a rise in rental rates and property values. Together, these two factors equal a property that has the potential to not be vacant for long periods of time and multiple openings to renew or start leases at market-adjusted rates.
One more thing to consider is that expense reimbursements, another lease component, is an additional way real estate investing is able to potentially pace inflation. Leases pass some form of a property’s current operating expenses down to their tenants, regardless of the type of building structure. As utility and maintenance costs rise due to inflation, landlords or building owners can be at least partially insulated from the effects on the property’s cash flow.
It is clear, then, that real estate investing — particularly investing in multifamily housing properties — can potentially be a good hedge against inflation that our current market has to offer. Real estate investing is often considered a path towards savings preservation in an inflationary and unpredictable economy.
It’s quite easy to see why investors have flocked to real estate in times of economic uncertainty. Regardless of the situation, housing will always be needed, and thus, very likely in demand. An investment property that is purchased and held onto for the long term has the potential to be a secure way to grow the original investment into something more substantial down the road.
Alternatively, if investors can’t — or simply don’t want to – own and manage the investment property themselves, they can consider real estate trusts (REITs), intuitional real estate funds, and Delaware Statutory Trusts (DSTs). How one decides to go about real estate investing is entirely up to them; it is, and should be, a personal financial decision. But it might be worth your while to inform yourself about all of your options and assess from there — or consult with a growth opportunity expert like the team at Perch Wealth.
Why is investing in a DST a potentially attractive real estate investment option?
If your bottom line is to seek wealth preservation during an inflationary economic period, then investing in a Delaware Statutory Trust, or DST, is potentially an extremely attractive real estate investment option. A DST is a commonly used structure for those looking to fractionally invest in real estate.
A DST is a way for investors to own real estate with the possibility of earning passive income and zero management responsibility. Most investors don’t typically think through whether they are interested in active vs. passive ownership of real estate property, and as such, get into situations that they feel they aren’t qualified for, interested in, or benefiting from in the ways that they would like to be. For a first-time or relatively new investor, investing in a DST is a great introduction to a potentially passive income stream and accumulation of passive wealth.
There are two primary ways that an individual can invest in a DST. The first is through a direct cash investment. For example, maybe you’re new to real estate investing and simply want to get your foot in the door; you might look to invest $50,000 in a DST to gain a foothold in the real estate industry. The second is by utilizing a 1031 Exchange.
Many investors are actually unaware that they can utilize a 1031 Exchange to invest in a DST, but there are many possible benefits to doing so. By doing a 1031 Exchange, you can likely maximize the current height of the real estate market and diversify your funds into multiple DSTs that are geographically varied and in distinct asset classes, helping to mitigate and possibly minimize the overall risk to your capital. If you’re interested in learning more about 1031 Exchanges, DSTs, or more alternative real estate investment strategies, you can speak with one of Perch Wealth’s financial professionals today.