For politicians and the kind of people who pay attention to the Federal Reserve, inflation gets a pretty bad rep: economic villain that eats your retirement savings.
Sometimes, that’s true. Other times, it isn’t. And if you’re a newer investor, figuring out exactly how inflation — an unavoidable economic reality — implicates your strategy and returns is both difficult and important.
So . . . what is inflation?
Inflation is a decrease in the purchasing power of money.
The more complicated answer is that ‘inflation’ is an economic term of art. When someone says “X is inflated,” they mean “there is more of X than there used to be, or X is larger than it used to be.”
X could mean prices, costs, wages, or the money supply.
Real estate investors think about price inflation most frequently, which just means the same good or service costs more money than it used to.
Price inflation happens for a few reasons.
First, price inflation with respect to a particular good (say, bananas) could mean the supply of the good has decreased. Particularly bad banana harvest means fewer bananas in the world.
Let’s take you back to social studies and the basics of supply and demand. Rarer goods command higher prices.
The same number of buyers are competing for a smaller amount of the good, so sellers can afford to charge higher prices without restricting their ability to sell their entire stock.
Decreasing the supply of a good while holding demand constant results in higher prices. The only way supply deflation won’t result in price inflation is if demand changes. If half of the banana buyers spontaneously decide that bananas actually aren’t that tasty, retailers cannot charge a higher price because the demand doesn’t exist.
Price inflation could mean the supply of money has increased (for instance, because the Federal Reserve is offering lower interest rates on bank loans, or because someone found $3 trillion in a hole in the ground in Arizona). All else equal, less-rare goods command lower prices. So, increasing the supply of money means that the price of money decreases, because there’s less scarcity driving up the value. In other words, inflation in the money supply tends to cause price inflation.
Tl;Dr: price inflation means your dollars don’t buy as much stuff as they used to, and that tends to happen when there’s either more dollars or less supply of stuff on the market.
How will inflation affect my investments?
Here’s the complicated thing about inflation: the prices of different goods and services don’t necessarily change at the same time, rate, or degree.
For investors, that means mismatches are potentially sources of either profit or loss. Successful investors deploy strategies that allow them to compensate for economic hardships and take advantage during periods of economic growth.
One of the reasons we think real estate is the best asset class for risk-adjusted returns is that inflationary environments tend to be good for real estate investors. Inflation is a debtor’s friend, and much of real estate investment is funded by debt.
When real estate investors acquire property via leverage (e.g., paying 20% of acquisition price up front in cash, and mortgaging the rest), they gain both an opportunity and a burden. The burden is mortgage payments. The opportunity is to earn returns on the bank’s money.
Here’s how inflation helps this strategy:
- Investors who use leverage (i.e. debt) will usually have a fixed-rate mortgage. If inflation occurs during this period, investors owe the same payment every month, while their opportunity cost functionally decreases.
- Mortgage terms are longer than leases. This means investors can adjust rents to track increases in their own costs. The mortgage payment stays the same, while rents go up forever.
- This effect is amplified for investors who own residential properties, especially multifamily ones. Multifamily leases are typically renewed annually, which means multifamily investors can move more quickly to adjust to changing market conditions.
Investors in other assets (for instance, the stock market) don’t have these advantages. When you buy in with your own money, and cashing out doesn’t come with tax protections like 1031 exchanges, your returns are at the mercy of fluctuating asset prices.
If inflation strikes, the value of your holdings decreases and there isn’t much you can do about it. Real estate investors, on the other hand, have the power to do something about the changing conditions by adjusting their price-to-cost balance.
Concluding Thoughts
Inflation is a complex concept that can both help and hurt investors, depending on factors like illiquidity tolerance, preferred exit date, leverage, customer base, and more.
The basic proposition that real estate is an effective hedge against inflation is fairly uncontroversial. This is why we believe every investment portfolio should include real estate assets.
It’s practically inevitable that inflation is going to impact your portfolio at some point. When that happens, hedging potential losses and decreasing your overall risk profile is a compelling approach — and real estate comes with advantages to make that possible.
