Consumers can feel the strain of inflation on checkbooks and wallets. Prices have increased more than 7%. Energy is probably the biggest individual component of the increase and housing prices could also rise as much as 5% over the upcoming year.
What does inflation mean for real estate investors?
How inflation works
Inflation is a decrease in the purchasing power of money.
Inflation is often the result of an increase in the money supply. When the Federal Reserve buys bonds with treasury funds, it increases the quantity of dollars in circulation, which decreases the value of the dollar and increases (inflates) prices of goods and services.
Inflation isn’t a single arrow on a chart. It’s often multiple arrows, sometimes moving in different directions, or moving in the same direction at different speeds. The relationship between dollars and goods and services can be direct or indirect. When prices for different goods and services change at different rates, investors may gain or lose money.
So, that’s the critical question: not the degree to which costs — including the costs of labor, housing, and consumer goods — rise, but the relative changes in costs over a given period of time.
How inflation affects real estate
Our experience of investing in real estate during downturns and upswings verified that inflation is a debtor’s friend. And, since much of real estate investment is funded by debt, this means inflation can benefit real estate investors.
- Investors who use leverage (i.e. debt) will 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.
A case study
In an inflationary environment, two real estate investors collect $80,000 net operating income (NOI) on a $1 million property.
Investor A is running 80% leverage and Investor B is unlevered (meaning Investor B did not borrow capital to purchase the property).
- Financed 20% of the acquisition price out-of-pocket ($200,000)
- Makes payments on a 10-year, 5% mortgage for one year ($84,000)
Throughout the year, rents increase by 8%, which goes to the bottom line. Property value also appreciates 8%.
The asset’s market value is now $1,080,000, and its annual revenue is $80,6400. (This is a simplistic assumption because, in an inflationary environment, operating expenses have also probably increased. But probably to a lesser degree than the rents, especially if you’re using a fixed-rate contract.)
Both investors can produce returns in two ways: a positive NOI and appreciation.
There are two important differences between Investor A and Investor B.
In cash-on-cash terms, Investor A comes out ahead.
If Investor A pays 5% on the loan, and gains an 8% increase in cash flow from rent increases, s/he pockets the 3% margin that s/he earned with someone else’s money.
As long as inflation continues, Investor A collects a premium that Investor B can’t (the total cash spent is lower for the levered investor). This means that an identical absolute increase in rent revenue benefits Investor A.
Both investors have the same NOI. But when they want to sell, cap rate matters. The increase in rent revenues means that the asset is worth more. If the cap rate remains constant, the market value of the asset will increase with its NOI.
If this happens, Investor B pockets the difference between market value before and after appreciation: $80,000, or 8% on his $1 million out-of-pocket investment.
Investor A, who invested only $200,000 out-of-pocket, earns a 40% return on the same $80,000 appreciation.
This is one of the fundamental reasons why real estate investment produces strong returns: cheap debt plus cap-rate compression means investors are virtually guaranteed to make money.
However when inflation strikes, cap rates might not compress. If cap rates rise with inflation, and asset prices fail to increase at the same rate as rents, the math changes: although the levered investor maintains the cash yield advantage, he loses a portion of the equity advantage because the asset’s market value hasn’t increased proportionally to rent growth.
Fortunately, this seems like an unlikely scenario. Cap rate is the relationship between an asset’s NOI and market value, but it’s also an expression of an unlevered investor’s expected annual return. In this sense, cap rates are equal to the risk-free rate plus a risk premium. If the risk-free rate goes up, cap rates will rise with it.
Inflation aside, cap rates have been falling for years (especially in the multifamily space). ]Cap rates are more stable than the interest rate. If the market thinks the risk premium is constantly shrinking, that can counteract some of the upward movement in the risk-free rate. While that theory isn’t proven, it does explain why interest-rate blips in past years haven’t prevented the slow, steady decline in cap rates.
Again, multifamily has the advantage: whether the risk premium expands or contracts depends on the asset class. Risk premium has been decreasing in multifamily because of a set of housing policies designed to ensure the availability of stable, affordable housing for working-class families.
Multifamily is the best asset class for inflation. When costs increase, multifamily has a stable cash flow and investors can adjust prices to match market trends. Multifamily assets are able to keep the arrow pointing up and to the right. Also, viable workforce housing is an important policy priority. The government will try to ease economic hardship on workforce housing during recessions.
For investors worried about inflation, it’s the perfect place to be.