Most people have no idea how inflation affects real estate.
Unfortunately, some are making fatal decisions based on fear & anecdotes.
Lately, I have been spending a couple of hours every day investigating the past inflationary periods to de-risk my strategy.
Mainly data diving and studying some really long-standing investors like Donald Bren, Sam Zell, etc
This post distills all my key findings.
I'll first radiate the insights and then talk about the 'so what' and how you can apply it to your strategy.
Let’s dive in:
It's known that with inflation, consumer prices increase but what is the impact on RE?
Inflation has some ripple effects on RE:
👉higher interest rates
👉Higher rents and expenses
👉long-term debt gets devalued
👉construction gets more expensive
1) Higher mortgage rates
Speaking in broad strokes, as inflation grows, so do interest rates.
Central authorities typically increase short-term rates in a fightback against rising prices.
More consumers borrow when the rates are low, leading to more spending, thereby fueling inflation.
So when interest rates are raised to fight inflation, consumers will lean more towards savings than spending because returns from higher interest rates are more appealing.
2) Rents and expenses
Past trends show rent prices have tracked high waves of inflation.
“American Housing Survey shows that the median rent increased by an average annual rate of 8.5% in the 70s, which exceeds all measures of inflation.”
However, suppose the investors are operationally lagging and not keeping rents up with the inflation.
In that case, inflation can backfire, so it’s vital to stay ahead of the game and not get tied into long-term leases.
3) Existing debt gets cheaper.
My existing mortgage payments are fixed, so I am paying the same amount each year.
Therefore, debt as a percentage of your total revenues decreases because revenues will increase with the rent increase.
= improving your cash flow
4) Development and Rehab are more expensive
As the cost of materials and labor increases, the development projects will be more expensive, so important to account for extra costs while running your return analysis.
One more thing: 👉Asset prices
Historical data shows prices have had no correlation with rising mortgage rates in the long term.
In theory, prices should decrease as new debt gets more expensive, indicating that there are other macros at play like supply shortage, etc.
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🤔So, is real estate a hedge against inflation?
Considering the above factors, real estate could be a haven in inflationary periods, especially if you get in at the right time or already have investments.
There are 2 drivers for the above conclusion.
✔️Rents rise with inflation
✔️The debt on your asset remains the same if you have a long-term fixed-rate loan.
Though, like any investment, there are risks to mitigate.
❌ The cost of a new loan will increase, putting downward pressure on your cash flows
❌ Demand for real estate will also decrease, making exits harder
❌ New real estate development is more costly.
The net sum is positive, considering both the advantages and drawbacks of inflation.
Here is I reformed my strategy:
- Be diligent in raising rents
- Make timely exits when the overall return on equity starts to yield lower than the initial return on investment.
- Make smart acquisitions with higher cash flow buffers upfront
- Invest for the long-term, meaning no flips or other short-term exit projects - to dilute the risk of getting caught in a real estate bubble
- No major rehab projects as construction costs would rise.
Best of all, the risk is internal and controllable as opposed to other instruments like stocks, where you most definitely have little influence on the trajectory of your asset performance.
Thus, I will continue to invest like I always have because I had always implemented these guardrails even when I started.
I expect any down cycles to have no impact whatsoever on my portfolio.
That's it, friends!
I hope this analysis helps you make educated decisions in time to avoid any drastic impacts.