Real estate is often utilized to diversify one's investment portfolio and hedge against inflation. But does this really work in an inflated economy, and what does “hedge against inflation” really mean?
To help answer those questions, we’ll take a look at how and why inflation occurs, and what happens to real estate during periods of inflation.
- Inflation is the increase in prices over a certain period of time, such as rising home prices or rent prices.
- Common causes of inflation include excess money supply, supply and demand shocks, and the general expectation that prices will rise.
- Investors use real estate as a hedge against inflation by capitalizing on cheap mortgage interest rates, passing through rising costs to tenants with higher rent prices, and benefiting from rising home values over the long term.
What does inflation mean?
Inflation is the rate of increase in prices for a set of goods or services over a certain period of time, usually a year. According to the U.S. Bureau of Labor Statistics, the 12-month change in selected categories of consumer prices has increased by 6.2% as of October 2021, more than double the Fed’s publicized inflation target of 2%.
Another way of thinking about inflation is that the purchasing power of each dollar is reduced because prices are rising.
As the Federal Reserve reports, since 1913 the average purchasing power of the consumer dollar in U.S. cities has declined by about 96.5%. In other words, $1 a little over 100 years ago is only worth just 3 ½ cents today.
The fact that a dollar buys less as time goes on is one reason why it costs more to gas up a car, buy a gallon of milk, rent a home, or purchase a single-family rental property than it did even a few short years ago.
Common causes of inflation
It’s no secret that nearly everything is becoming more expensive, but what is it that causes inflation? A recent report from the International Monetary Fund (IMF) lists some of the factors that create inflation:
- Lax monetary policy – also known as money printing – increases the money supply which in turn causes each unit value of currency to decline. For example, the $5 trillion stimulus during the pandemic is more than 3 times the aid approved during the Global Financial Crisis of 2008-2009.
- Supply shocks caused by natural disasters or business lockdowns are also inflationary in nature because prices increase when there is more demand for an item than there is supply.
- Demand shocks are another cause of inflation, such as when the stock market rallies due to lower interest rates or investors out-bid one another to purchase single-family rental (SFR) homes for the potential yield that the properties generate.
- Expectations of rising prices can also become self-fulfilling, according to the IMF, because when people or businesses expect prices to rise these expectations are built into price adjustments like wage negotiations or rent price increases.
How inflation affects real estate
In less than 10 years, the value of a typical middle price tier single-family house in the U.S. has increased by over 90%, according to Zillow (through Sep 30, 2021). Looking forward, forecasts indicate that home prices will rise by 13.6% over the next year.
There are several reasons why real estate prices rise during periods of inflation.
One reason why real estate prices rise during inflationary times is that investors search for assets that generate yield above and beyond the rate of inflation.
Rental income collected from a tenant is used to pay for operating expenses, property taxes, and the mortgage. Any remaining money at the end of each period is the return on investment, which is expressed as a capitalization (cap) rate. A cap rate is calculated by dividing a property’s net operating income or NOI by the property purchase price.
For example, single-family rentals (SFRs) currently have average cap rates of 5.8% according to Arbor Research, while some rental homes listed for sale on the Roofstock Marketplace have projected cap rates of 7% or more.
By comparison, cap rates on multifamily properties are about 5%, the 10-Year Treasury yield is around 1.5%, while high-yield savings accounts offer an annual percentage yield of 0.60% or less.
Limited amount of real estate
A second reason why real estate prices tend to rise with inflation is that there is a limited amount of property compared to fiat currency. As the money supply grows due to greater amounts of money printing, real estate prices should rise.
To illustrate using a simplified example, assume that a pretend economy has $1 million dollars of total money and that there are 100 houses with no other goods or services available. Each house would be worth $10,000, assuming that each property was identical.
Now imagine that the local central bank printed an additional $1 million overnight. There would now be a total of $2 million dollars in the economy and each home would be worth $20,000. As the IMF has already explained, money printing is one of the factors that create inflation, and also cause real estate prices to rise.
Housing construction costs increase
Inflation also causes the cost of building a home to increase, due to rising wages and more expensive materials, supplies, and land costs. In turn, home builders pass through the cost of building a new home to home buyers and real estate investors, which is another reason why real estate prices have been rising.
As the National Association of Home Builders (NAHB) recently reported, overall building material prices have increased by over 19% during the past 12 months and 13% year-to-date. Homebuilding materials include items such as lumber, gypsum board used to finish walls and ceilings, and ready-mix concrete.
How investors use real estate as an inflation hedge
During inflationary periods, prices for nearly everything rise, including housing costs and rent prices, and oftentimes mortgage interest rates as well. There are 3 main ways investors hedge against inflation and rising prices with real estate.
- Capitalize on cheap money: Mortgage interest rates are at historic lows, currently averaging 3.07% for a 30-year fixed-rate mortgage, according to Freddie Mac (as of October 2021). Low-interest rates offer an investor the opportunity to take advantage of cheap money today to avoid paying higher rates in the future.
- Export inflation to tenants: Owning a single-family rental property may offer an investor the opportunity to pass through rising costs to a tenant in the form of higher monthly rent. As the most recent Single-Family Rental Investment Trends Report from Arbor notes, vacant-to-occupied rent growth has increased by 12.7% year-over-year, compared to the current reported rate of inflation of 5.4%. Since May 2020, annualized 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 2.7% to 7.3% higher than inflation.
- Benefit from rising asset values: Housing prices historically increase over time, which is another reason why investors use real estate as a hedge against inflation. According to the Federal Reserve, the median sales price of houses sold for the U.S. has increased by 345% since Q3 1990, and by nearly 20% since Q3 2020.
What happens if interest rates rise?
As inflation increases, interest rates also tend to rise, because central banks usually raise short-term interest rates in an effort to “fight inflation.”
For example, the most recent period of extended inflation was between April 1989-May 1991 prior to the first Gulf War. Rapidly rising oil prices and economic uncertainty lead to a bout of high inflation, according to a blog post from The White House.
During that same time period, Freddie Mac reports that mortgage interest rates ranged between 11.05% and 9.47%.
When mortgage interest rates rise, money becomes more expensive to borrow, which may lead to fewer buyers financing, making larger down payments to help reduce the monthly mortgage amount, or not purchasing a home at all.
During the period between April 1989-May 1991, the median sales prices of houses sold remained about the same, based on data from the Federal Reserve.
Real estate prices tend to rise during periods of inflation caused by rising prices and excess money supply. To help offset the loss of purchasing power of the dollar, some investors use real estate as an inflation hedge to generate yield above the rate of inflation by locking in low long-term mortgage interest rates, exporting inflation to tenants by raising rents, and profiting from the potential increase in home prices over the longer term.