Investors have a lot to consider, especially when they weigh all the pros and cons of a specific investment choice. Real estate is known for being an asset that can steadily increase in value over time. In fact, real estate has consistently risen in value almost every single year.

There have been a few exceptions, including the real estate collapse that started in 2006. But real estate is still considered to be a reliable investment choice for anyone who is in it for the long haul. It’s also an investment that can provide a hedge against inflation, but the question is whether that’s really true. And if it is, what does that actually mean?

What Inflation Means

Inflation refers to the rate of increase in prices for a specific set of goods or services over a period of time (usually within a single year). According to the U. S. Bureau of Labor Statistics, the 12-month change of consumer prices within certain categories has increased by 6.2% as of October 2021. This is twice the amount of the Fed’s publicized inflation target (which was 2%).

You can also think of inflation in terms of the purchasing power of each dollar, which would reduce because of rising prices. Since 1913, the Federal Reserve reported a 96.6% decline in the average purchasing power of the dollar in American cities. In other words, a single dollar just over 100 years ago would only be worth 3 1/2 cents today. The fact that the dollar buys less over time is the main reason why it costs more to put gas in your car, buy a gallon of milk, rent a home, or buy a single-family rental property than it did just a few years ago.

Common Causes of Inflation

There are a lot of things that can cause inflation. But according to a report from the International Monetary Fund (IMF), some of the common causes include:

• Quantitative easing or money printing.  This is a more relaxed monetary policy which will increase the money supply and therefore cause its unit value to decline. For example, the $5 trillion stimulus package that was issued during the pandemic is more than three times the aid that was approved during the Global Financial Crisis of 2008-2009.
• Supply shocks caused by natural disasters or business lockdowns can cause inflation, because prices will increase if there’s more demand for an item relative to its supply.
• Shocks in demand can cause inflation. This can include situations when the stock market rallies because of lower interest rates or when investors try to outbid each other for the purchase of a single-family rental (SFR) for the potential return that the property can generate.
• According to the IMF, the expectation of rising prices can be self-fulfilling. When people or businesses think that prices will rise, these expectations get built into price adjustments (such as wage negotiations or rent increases).

You may have noticed that gas prices change on a regular basis. This is often the result of how much supply is available at that time, which is determined by how much manufacturers release into the market as well as by how much drivers are on the road and using gas. If people aren’t driving as much and the supply increases, you’ll see lower gas prices. But when companies aren’t releasing as much of their oil and gas products, you’re more likely to see higher gas prices.

How Inflation is Measured

One of the common ways that inflation is measured is by looking at the Consumer Price Index (CPI), which is published through the Bureau of Labor and Statistics (BLS). It tracks changes in the price of different categories of goods and services – some of which can include:

• Food
• Clothing
• Cars
• Commodities
• Gas

Another way that inflation is measured is with the Wholesale Price Index (WPI), which measures how prices from wholesalers or manufacturers change.

How Inflation Can Affect Real Estate

According to Zillow (as of September 30, 2021), the value of a medium-priced single-family home in the U.S has increased by over 90% in the last ten years. The company also forecasted a 13.6% rise in home prices in the following year.

Here are some of the reasons why real estate prices rise during times of inflation:

It’s an Income Generating Asset

One of the reasons why real estate prices rise during times of inflation is because investors will look for assets that can generate a return that’s above and beyond the rate of inflation. Rental income paid by a tenant is used to pay for operating expenses, property taxes, and the mortgage. Any money left over at the end of each period would be their return on investment (ROI), which is expressed as a capitalization rate (or “cap rate”). This is calculated by dividing the property’s net operating income (NOI) by its purchase price.

According to Arbor Research, single-family rentals (SFR’s) currently have an average cap rate of 5.8%. Cap rates on multifamily properties are about 5% with a 10-Year Treasury yield of about 1.5%. In comparison, high-yield savings accounts will offer an annual percentage yield of 0.60% or less.

There is a Limited Amount of Real Estate

Real estate prices tend to increase during times of inflation because there’s a limited supply of properties compared to fiat currency. As the money supply grows because of more money printing, real estate prices will naturally increase. If a pretend economy has $1 million of total money and there are 100 houses with no other available goods and services, each house would be worth $10,000. This is assuming each property was identical.

If the local central bank printed another $1 million overnight, there would be a total of $2 million in the economy and each home would be worth $20,000. While this is a simplified scenario, money printing is one of the primary factors that can cause inflation. And it can cause real estate prices to increase as well.

Housing Construction Costs Can Increase

Inflation can cause the cost of building a home to go up, which is the result of rising wages, more expensive materials and supplies, as well as the overall cost of land. This can cause home builders to pass the cost of building a new home to home buyers and real estate investors, which can cause real estate prices to rise.

According to a recent report by the National Association of Home Builders (NAHB), the cost of building materials has increased by over 19% in the last 12 months and by 13% so far this year. This includes lumber, gypsum board used to finish walls and ceilings, as well as ready-mix concrete.

How Investors Can Use Real Estate as a Hedge Against Inflation

During periods of inflation, the prices for almost everything will increase (including housing costs and rent prices). In many cases, mortgage interest rates will increase as well. Here are three ways that investors can use real estate to hedge against inflation and rising prices:

• Capitalize on Cheap Money – Although mortgage rates are rising they are still at historic lows, which is currently around at 5% for a 30-year fixed rate mortgage. Low interest rates can give investors the opportunity to take advantage of cheap money so they can avoid paying higher interest rates later on.
• Export Inflation to Tenants – Owning a single-family rental property can give investors the opportunity to pass rising costs to a tenant in the form of rent increases. According to the most recent Single-Family Rental Investment Trends Report from Arbor, vacant-to-occupied rent growth has increased by 12.7% year-over-year. This is compared to the current reported inflation rate of 8.5%. Since May 2020, annual rent growth has averaged 8.1% for single-family homes (compared to a historical average rent growth of 3.3%). In other words, recent rent price growth is significantly higher than the current rate of inflation.
• Benefit from Rising Asset Values – Housing prices have historically increased over time, which is another reason why investors use real estate as a hedge against inflation. According to the Federal Reserve, the average sales price of houses being sold in the U. S. has increased by 345% since the third quarter of 1990 and by almost 20% since the third quarter of 2020.

Inflation can be a good thing for many property owners, because the value of their home will rise according to the inflation rate. Because of low supply and high demand, sellers can increase their selling prices. And in many cases, they can get offers that go above that. That’s why periods of inflation are great times to sell, even though much harder to buy.

What Can Happen if Interest Rates go Up

Interest rates tend to go up as inflation increases, because central banks will usually raise short-term interest rates in an attempt to “fight inflation.” The most recent period of extended inflation was from April 1989 to May 1991, which was prior to the First Gulf War. Oil prices were rapidly increasing, and economic uncertainty led to a period of high inflation. During that same time period, Freddie Mac reported mortgage interest rates to be between 9.47% and 11.05%.

When mortgage interest rates go up, it becomes more expensive to borrow money (which can lead to less buyers having access to financing). This results in larger down payments to help reduce the monthly mortgage amount, or it can lead to someone not purchasing a home at all.

Final Thoughts

Real estate prices tend to go up during periods of inflation because of rising prices and excess money supply. To offset this loss of purchasing power, some investors use real estate to hedge against inflation so they can generate a yield that’s higher than the current inflationary rate. They can do this by locking in a lower long-term mortgage interest rate, passing it on to tenants by raising rents, or by profiting from the potential increase in home prices over the long term.

If you want to know more about real estate investing and how it can give you more protection against inflation, be sure to get in touch with Trevor Shakiba at Shakiba Capital.