How Real Estate is a Great Hedge Against Inflation
The impact of inflation in 2022 and into 2023 is hard to ignore. Prices have increased sharply on a broad variety of goods, from groceries to gas, leaving families and investors alike pinching pennies and worrying about what the future may bring.
For risk-averse investors, selling real estate for the promise of fast profits or otherwise taking what seem like less risky steps might be appealing – especially if liquidity is in question. However, impulsive selling is rarely the answer in times of economic turmoil, and that includes periods of high inflation. In fact, real estate can be a great hedge against inflation when leveraged properly.
Here is what you need to know about inflation and real estate investing, including the steps investors can take to make the most of their investments – no matter what the market has to offer.
What Is Inflation?
Inflation refers to the purchasing power of a dollar. In periods of high inflation, a dollar does not go as far as it does in a period of lower inflation. This is why prices can fluctuate from one year, or even one week to another. In general, inflation builds over time – this is why something that cost $1 in 1950 may cost $10 today – but certain economic factors can impact how inflation impacts various markets from a short-term perspective.
So, what drives inflation? Unfortunately, there is no easy answer. Inflation can rarely be tied back to one specific factor; it is usually a medley of varying elements. Take, for example, the COVID-19 pandemic. Inflation rose during this period due to business shutdowns, which led to a reduction in goods and services available, in many cases without an accompanying reduction in demand. Money supply created additional inflationary pressure: When consumers have access to additional income (such as government subsidies), prices tend to rise. Further, a simple anticipation of these events can lead to rising prices, making it harder for consumers to afford life basics.
With so many factors that can play into the state of the economy, anticipating how the market is going to change is next to impossible. However, the right assets – like using real estate as a hedge – can reduce risk, no matter how things evolve.
Inflation and Investment Strategy
When life costs more than ever, it is natural to be concerned about the impact to your investment portfolio. In times of high inflation, net returns on stocks, bonds, and fixed-rate assets can decrease, leaving investors unnecessarily exposed. For those newer to the investment space, it may be natural to assume real estate will be similar – leading to the increased potential for impulsive choices to minimize as much loss as possible.
However, in terms of real estate, the opposite tends to be true. There will always be value to be had in real estate, even as the value of the assets in an investment account lose their buying power. Since real estate holds intrinsic value, when used properly, it can be an effective hedge against inflation, protecting portfolio returns and setting investors up for future success. To best benefit, it is important to know exactly how and why real estate can be used to weather periods of high inflation to keep a portfolio growing and developing.
The Innate Advantages of Real Estate
Real property offers a lot of value in comparison other forms of investments, for a few reasons. A major component is, of course, that there is intrinsic value in real estate. Land is a finite resource. Property is not theoretical; it is an asset people need to survive. It is also, in many areas, a commodity. There is not an endless supply of properties to choose from, requiring renters and homebuyers to pick from an existing market. This facet of real estate, as compared to less tangible assets like stocks, makes it an excellent choice for those looking to diversify their investments and minimize inflation risks. It’s important to note that new homes are built, but population increases and lower than expected new homes built, have led to an overall decrease in properties available.
Everyone Needs a Home
In one way or another, everyone needs a home. This may be a standalone house, a condo, a townhouse, an apartment, or even residence in a group facility, like a dormitory. Regardless of its form, housing is a must in a way that other assets are not. This means there will always be a need for real estate. No matter how high inflation gets, housing will never cease to be important. Investors may need to be strategic about how to price properties, whether for rental or purchase, but if savvy about considering economic factors, real estate can withstand even the worst economic conditions.
Properties Appreciate
When home prices rise, so does the value of real estate. This means that, effectively, the longer a rental property is owned, the more it will eventually be worth. This can fluctuate from year to year – one year may result in a higher value than another – but in time, property values will rise, resulting in higher profits. How the stock market will rebound can vary significantly, particularly when investing in an individual company’s stock, since stock value is tied to company performance. By contrast, a well-maintained property will almost always continue to appreciate over time.
It is also important to note that home prices often correlate with inflation, but interest rates do not always follow the same trends. This means that while it can be costly to purchase during these period – not always, depending on other market factors, but often – low interest rates can make the investment worth it regardless. With future appreciation in mind, this can be particularly true.
Driving Income With Rent Prices
For investors who hold and manage rental properties, there is a certain level of control investors have that is unavailable in passive options like stocks and bonds: the ability to control rental prices. There is no standardized process that dictates pricing; investors can largely choose to charge tenants whatever they would like, within the range of the local market.
There are a few ways landlords can control rent to keep prices in line with inflation, or in line with personal needs, without shocking tenants into finding other accommodations. Planning wisely with favorable property lease provisions can ensure a steady source of income prepared to weather varying market conditions.
Consumer Price Index (CPI)
A less common strategy today, indexing against the Consumer Price Index (CPI) was a popular methodology during the 1970s and 1980s when inflation challenges were more frequent. The Consumer Price Index is a government-maintained measure that assesses changes in the cost of goods and services over time. Under a CPI index strategy, landlords raise rents when the CPI rises, and reduce it again when CPI falls. This effectively keeps rent in line with what consumers are spending elsewhere in their lives.
This strategy, especially as it is foreign to many younger residential renters, may not be compelling for those apartment-hunting. However, commercial real estate tenants are likely more used to seeing this; what’s known as an escalator clause can still be found in many of these corporate contracts – a benefit for investors with commercial property holdings.
Short-Term Leases
Leases with a termination clause, like a year-long lease versus one that is indefinite, are popular with residential landlords for a reason: the chance to adjust rental rates based on market demand and factors like inflation. When rental rates are not tied to anything but a short-term contractual agreement, landlords can tweak as needed.
There are more limitations in California than in other states, however. The Tenant Protection Act of 2019 put a cap on how often landlords can raise rents, limiting increases to once or twice a year depending on lease terms. In addition, some areas statewide also limit the percentage by which rents can increase from one renewal term to another. Savvy planning can mitigate these roadblocks, though, leaving landlords wiggle room to adjust rates when most necessary. When in doubt, be sure to consult a real estate attorney to maximize rental income without violating state and local laws.
It is important to note that many tenants will not tolerate rent increases more than several percentage points per renewal period. Raise prices too high, too quickly and tenants are far more likely to terminate their leases and look elsewhere, so be sure to keep this potential barrier in mind.
Hands-Off Opportunities
One of the reasons many investors are hesitant about getting into real estate is the perceived time investment. Yes, property holds a lot of potential, but the time required to maintain a property, handle tenant requests, organize things like billing and rent collection, and advertise vacant units can overwhelm investors either new to the game or who generally focus on the fix and flip aspect of real estate investment. However, investing in real estate does not mean making property management a full-time job. Many investors outsource landlord responsibilities, particularly those with large portfolios.
Hiring a third party to manage the day-to-day tasks can be costly depending on individual needs, but the expense can be well worth it. In a period of high inflation, taking advantage of outsourcing can allow investors to put the hard part in someone else’s hands. This outsourcing frees up valuable time to maximize opportunities elsewhere, whether that means working toward additional property acquisitions or focusing on other investment avenues.
Challenges in Using Real Estate to Hedge Against Inflation
There are clearly upsides in using real estate investments as a hedge against inflation, but that does not mean it is always the right strategy. There are some challenges to keep in mind, particularly for investors who do not have an adequate approach to investment already in place. These include:
- High costs: There is no way around it – managing real estate investment needs can be costly. This is especially true for those who have properties that need renovations to demand the higher rents that a landlord desires in periods of high inflation. When spending is tight in other areas, the investment required to keep a property up to par is not easy. Investors may want to consider ways to minimize costs, or other avenues that can offer greater yields without the impact of things like property taxes, insurance, legal fees, mortgage insurance, advertising, office expenses, and anything else that may apply.
- Increased Time Commitment: While there are ways to offset the time commitment in real estate investing, this can mean higher expenses that are not always tenable when cash is stretched thin. For investors who have day jobs, other properties not being used as rentals, or alternate investment obligations outside of real estate, the demands of managing property can be a steep ask. When too much time would be required to drive income through rental properties, pivoting in a different direction may be a better choice.
- Strategy Complications: Rental property is most effective as an inflation hedge, unless fix and flips are in a good position to sell as market prices rise. As such, some investors may need to pivot strategies or acquire new properties to be able to use real estate as a way to make up for inflation-related deficiencies in other parts of an investment portfolio. Some investors may have the savvy to pull this off, or have experience doing this in past inflationary periods, and will be able to tackle this challenge with ease. However, this will not work well for everyone, and weighing the pros and cons of pivoting is essential to long-term success.
For investors worried about potential drawbacks of using real estate as a hedge against inflation based on the current state of a portfolio, it is important to drill down into the numbers. This kind of analysis includes all applicable costs, any time requirements, and how current strategies may need to change to best accommodate the hurdles that investors can face due to inflation.
Inflation is a reality of the economy; at times, inflation will work to investors’ overall advantage, and at others, it can be a roadblock to overcome. However, for those invested in real estate, inflation can be an opportunity rather than a limitation. By seizing the upsides and maneuvering deftly around the potential challenges, seasoned real estate investors can use their holdings as a hedge against the downsides elsewhere in a portfolio.