How Inflation Affects Your Real Estate Investments

Inflation is a reality of the economic markets. Over time, costs rise, and the value of the dollar distorts. A one-bedroom home could be had for $20,000 or less in 1965, but today’s buyers need around 10 times that to find a nice property in most parts of the country. All prices are affected by the influence of inflation – and that includes real estate investment properties, especially as housing increases at a higher rate of inflation.

 

Overall inflation has been relatively low in the United States over the last decade, but the tides are starting to turn. Years of low interest rates and strong economic growth following the Great Recession are coming to an end, indicating that there is a strong chance inflation will soon rise at a more aggressive pace. While this is a natural part of the ebbs and flows of the economy, large shifts in inflation can add an extra layer of complexity in investing.

 

As experienced investors know, ignoring inflation in any investment capacity, real estate included, can be a poor choice. To best plan a portfolio and ensure purchases are a long-term success, understanding the influence that inflation can have is critical. Here is what you need to know about how inflation affects your real estate investments and what you can do to maximize your opportunities in a shifting economic market.

 

What Is Inflation?

Inflation is a quantitative measure related to the price level of goods and services. A paperback book may have been priced at $2 in 1970 but demands $10 today due to the influence of inflation. In essence, this reflects a decrease in the purchasing power of a dollar.

 

Inflation is usually expressed as a percentage; for example, inflation of 3% indicates that $1 last year now carries the purchasing power of $0.97. This seems like a minor shift on the surface with minimal immediate effects, but even small amounts can add up. A home priced at $150,000 five years ago would now demand $172,500 – a difference of $22,500. For a real estate investor, the effects can be costly, especially when materials or labor are added in. Without a change in strategy, or even simple comprehension of how inflation can affect pricing over time, it can be easy to fall behind.

 

The Elements of Inflation

Inflation isn’t a constant in the market. It can generally be attributed to three different economic theories, and each can play a role in the real estate market, but in varying ways. Simply understanding the risk of inflation in general isn’t adequate; real estate investors need to be aware of which form is driving inflation changes and how the specific state of the market can play a role in investing.

 

Built-In Inflation

Built-in inflation is a form of inflation that doesn’t necessarily rely on market movement. Instead, this concept is largely self-inflicted. Companies often increase prices marginally on an annual basis in order to cover the growing costs associated with the expectation of inflation. Whether or not the cost increases expected come to pass is negligible, but this kind of behavior does serve as a way to reduce the purchasing power of the consumer. Built-in inflation can be seen as a chicken or egg philosophical question: is inflation driven by the market, or is a portion of it influenced by companies attempting to prepare for inflation?

 

For investors, built-in inflation can be a factor when it relates to building materials, construction projects, or contracting costs. However, built-in inflation in unrelated sectors of the market may have little to no effect.

 

Demand-Pull Inflation

Demand-pull inflation, as the name implies, involves an excess of demand that surpasses the supply. Demand-pull inflation can happen on a small scale, with increases in particular areas of the market, or on a larger, more holistic scale. Low interest rates can be a driver of demand-pull inflation. With fewer consequences involved in borrowing, people have access to increased capital to spend. In this manner, demand-pull inflation can affect things like rent and property prices.

 

In some cases, a unique need that arises in the market can drive demand-pull inflation. For example, the spread of COVID-19 saw a significant uptick in personal protective equipment purchases, both on a personal and a business level. This allowed providers to drive prices up, both in order to profit as well as to meet the expenses involved in ramping up production.

 

Cost-Push Inflation

Cost-push inflation is generally the worst kind of inflation from a financial perspective. This form of inflation is related to the cost of the elements that go into the production of a product or implementation of a service. Cost-push inflation is heavily influenced by outside factors that may not have direct correlation to the current trajectory of the economy.

 

Factors like tariffs, treaty negotiations, and trade disputes can all influence the price of raw goods. In 2018, tariffs imposed on Canadian paper manufacturers drove prices on paper of all kinds, leading to increases publishing costs. This hurt both publishing houses and newspapers, resulting in higher prices for product purchases. This elevation in expenses could have been prevented as it was not driven by any natural force, but after political action played a key role.

 

The ramifications of cost-push inflation are generally more severe than those of demand-pull and built-in inflation. Economic growth is slower, and the long-term ramifications can be harder to control. In most cases, cost-push inflation is industry-wide, so turning to other companies for things like plywood is worthless if the lumber industry as a whole is facing struggles.

 

Cost-push inflation is by far the most damaging for real estate investors. The supply of products is there but the cost to acquire them can potentially be detrimental to the bottom line.

 

Real Estate Investment and Inflation

Real estate investing requires strategy under any circumstances, but this becomes even more true when economic variables start to shift. Inflation in particular can have a significant effect on whether or not investing is a wise decision.

 

Some investors continue to follow the same methodology when inflation is a cause for concern but barreling forward without taking time to evaluate how economic changes can play a role can be a dangerous game. Leaping before looking in an evolving market can lead to big risks without the assurance of big rewards.

 

For investors who want to safely navigate inflation, there are some strategies that can make a difference.

 

Properly Structured Leases

Many property investors don’t pay particular attention to the nitty-gritty of a lease deal as long as all major criteria are covered. However, now may be the time to dig a little deeper. The way a lease is structured can manage costs, keeping the expense associated with renting a property out under control.

 

A common cost-cutting measure in leases entails capping maintenance costs. With this strategy, costs to maintain a property are covered by the property owner to a certain limit. After this point, tenants are required to cover excess costs. Finding a balance can be a challenge – tenants will be largely uninterested in covering more than a small percentage of costs – but identifying the sweet spot can be very valuable. To avoid driving away tenants, property managers are encouraged to find a threshold that will allow for most routine maintenance while providing protection against higher costs related to abnormal events.

 

Leases structured in a way that passes some of the expense on to a tenant may not be possible in all areas. Some cities have tenant-favored property management laws that put the entire onus of necessary repairs entirely on the property owner. In these cases, there may not be a way to minimize the expenses associated with maintenance and management. Lease structuring can be easier with commercial tenants, as most protective policies apply to individuals, not businesses.

 

In addition to attempting to limit costs, property owners can also exclude utilities from coverage within a lease. For example, if water has historically been included in a lease, this can be left out in a new lease, with billing switching to the tenant. This kind of utility bill is usually small enough that it won’t deter a tenant but can provide substantial savings for owners of multi-unit dwellings.

 

Purchase Location

Location is always important when investing in real estate, but it becomes even more so in periods of inflation.

 

While inflation has the ability to destroy a weak market, at least temporarily, strong markets can usually withstand most economic shifts. Areas with high demand and no shortage of tenants or buyers who can afford average home prices are likely to feel less of a pinch than up and coming or waning neighborhoods.

 

Before writing off a city, be sure to break any analysis down to the neighborhood level. Even though a city on the whole may appear to be in decline, different pockets may still have a strong market. Substantial research can be the difference between a wise purchase and a poor purchase under any circumstances, but rolling the dice is far worse when the future is a little less sure. Periods of rising inflation may not be the best time to buy in general, particularly when the effects aren’t yet known, so don’t be afraid to take time to do homework and evaluate options.

 

Investors who are limited geographically may not be able to purchase in a more profitable market, but those with the ability to extend a purchase footprint are encouraged to do so.

 

Diversify with a Capital Stack

A capital stack refers to the funding methods used for the purchase of real estate. Normally, this is up to investor preference, with different investors preferring to use cash, loans, partner investors, or a combination of less formal alternative of those methods. During a period like a recession, however, it can be valuable to put more thought and effort into considering a capital stack with strategy rather than convenience in mind.

 

Both debt and equity play a role in diversification, which is valuable in times of higher than average inflation. As both debt and equity perform differently in different kinds of marketplaces, having a balance of both can be the most stable way to proceed.

 

In periods of higher inflation, debt usually underperforms, but can be an asset if situations reverse. Equity, on the other hand, acts as somewhat of a hedge against inflation. The balance of both components can benefit a portfolio, providing a little extra stability in uncertain times.

 

Investing is never a guarantee of profit, and that is especially true during economic shifts. While inflation is a reality that should be acknowledged one way or another, periods of higher than normal inflation or inflation spikes after a period of relatively little change can require extra caution. Before charging ahead with the same strategies, take time to determine how inflation may apply in the local market and what measures can be implemented now to prevent potential losses or lower profitability.

 

 

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