In simple terms, inflation represents the decreasing purchasing power of currency over time. In the United States, we witnessed a steady, gradual increase with a few periods of bust and boom. Just one hundred years ago, a dollar would go much further than it does today. In 1922, a product costing $1 might get priced at $17.63 in the current year. Several factors cause inflation. According to Forbes, “Supply and demand, fiscal policy, corporate policy and manufacturing costs can all lead to inflation. Before we cover how your real estate investments provide protection against inflation, let’s investigate and summarize the topic.
What Is Inflation Premium?
Investors that purchase financial assets must earn a greater interest rate to cover the cost of holding the investment when the cost of everyday goods and services rises. The inflation premium is the name for this higher rate. According to Xplaind, inflation premium is a “component of required returns that represents compensation” for endearing an investment’s performance. In investing terms, this is called inflation risk.
What Is Inflation Risk?
The nominal return gets calculated by examining financial outcomes without accounting for inflation. The real return, often known as the purchasing power, is the value investors should be concerned with. Inflationary risk is the danger that inflation will reduce an asset’s value, an investment’s performance, or an income source’s purchasing power.
“Inflation is a decline in the purchasing power of money over time, and failure to anticipate a change in inflation presents a risk that the realized return on an investment or the future value of an asset will be less than the expected value.”
Any asset or income stream with a monetary value could be subject to inflationary risk since its value will decrease in direct relation to the declining purchasing power of its dollar value.
Additionally, Investopedia notes that, “Lending a fixed sum of money for later repayment is the classic example of an asset that is subject to inflationary risk because the money that is repaid may be worth significantly less than the money that was lent.” Physical assets and equities may gain value from unexpected inflation since they are less susceptible to inflationary risk.
Why Is Real Estate Considered an Inflation Hedge?
Real estate is a well-known investable inflationary hedge, with its limited supply, owning commercial property is a great way to protect yourself from inflation.
Since 1972, inflation has averaged 3.99% per year, while commercial real estate earned 9.5% annually.
Compared to other investment types, real estate has three unique characteristics that make it appealing as an inflationary hedge. Un-invested, your money loses about 4% of its purchasing power annually. At first, this seems straightforward, commercial real estate provides roughly double the return on your dollar compared to the price of all other inflated goods over time.
The difference between the two to keep in mind is that inflation historically maintains a much more consistent upward trend than real estate, which tends to cycle through shorter appreciation and depreciation periods. The most patient commercial real estate investors will earn nearly 10% in average yearly returns.
Three Ways Real Estate Investments Protect You Against Inflation
1) Investing in Fixed Assets with Intrinsic Value
Inflation can occur on both tangible and intangible assets. Typically, unless periods of deflation occur, tangible assets will see a positive transformation in their revenue. Commercial real estate is no exception. In many cases, appreciation may grow the value of a property faster than the inflation rate resulting in your real estate investments providing protection against inflation.
Tangible assets have historically outperformed other investment types during periods of increasing inflation; they are especially suited to give investors a way to weather the present inflationary wave. There are many possible reasons for this. In general, the income of an asset may correlate with inflation, rising along with inflation.
Tangible assets like real estate and infrastructure typically do well during economic upswings as demand increases and rents go up. These asset returns have historically outperformed other areas of the economy under periods of high inflation.
2) Take Advantage of Fixed Mortgages
For real estate investors, a fixed mortgage refers to a fixed rate of interest over the life of the loan, while a variable mortgage refers to an interest rate that varies (usually goes up over time). Owning real estate investments during times of increasing inflation may hedge against that inflation for several reasons. As inflation rises, typically so will the value of your investment property. When this is the case, the LTV ratio of your asset’s mortgage will decrease, and your monthly mortgage will remain fixed as your property increases in value.
With your real estate asset appreciating, and your LTV ratio decreasing, your equity position grows stronger. This serves to provide protection against inflation better than cash in a savings account or other types of investments. For example, even though banks will pay higher interest rates during times of higher inflation, even these higher rates are unlikely to outperform inflation.
3) Create Wealth with Income Generation
Real estate generates income; typically, the rents you receive will also go up along with inflation. By raising your rents, if you receive a monthly check from your tenant for rent the following year, you should accept that same amount plus inflation because that dollar is worth more. The year after, you would receive that already inflated check with the newly added inflation again.
For example, you have one tenant paying $1,000/month rent. At a yearly inflation rate of 4%, you may choose to increase the rent to $1,040/month the next year and $1,082 the year after that. Income generation allows you to take advantage of a compounding return as an investor, with rents continuously increasing with inflation.
Getting consistent rent payments during an inflationary period may also give you a leg up, as other assets might not generate as much income. If you invest in a luxury car company, you might find its stock price devalued as inflation rises.
Why does real estate do well against inflation?
Rents are not the only aspect to consider when understanding how real estate investments provide protection against inflation.
Rents alone aren’t the only aspect of your investment to grow; keep in mind that commercial expenses like taxes and insurance are also subject to inflation.
An adequately orchestrated CRE business will receive rental income, surpassing these increased expenses. In multifamily apartment buildings, according to Forbes, “expenses are typically half the rental income.” As inflation increases, increased expenses may get eclipsed by the more significant increased revenue through raised rents. Sometimes an inflationary environment can benefit investors and drive augmented cash flows. Profit margins may even become widened.
Combining all three benefits makes it clear why real estate has historically been considered a hedge against inflation. Protecting yourself against inflation with a well-planned real estate investment is almost always a sound decision for the future.
In summary, real estate protects against inflation for three reasons. Properties are tangible assets that will always receive monetary compensation upon sale. The price of a building cannot drop to zero as even the land is always worth something.
As an investor, you might have a fixed mortgage on your investment property; this type of loan is advantageous during an inflationary period because your rates stay the same for you but are worth less to the lender over time. Finally, real estate generates monthly income. As inflation rises, you may raise each unit’s rent to market levels to compensate for the increase in prices of goods and services.
Real estate investments provide protection against inflation when you watch your collections and expenses closely and adjust and plan accordingly.
Guest article provided by: Northeast Private Client Group
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