Real Estate & Inflation: How to Make Sure You’re Fully Protected

Investing in multi-family real estate can produce reliable, tax-advantaged, passive cash flow, and it can also provide an effective hedge against inflation. This is because shorter term apartment leases allow for more frequent rent increases in response to increased costs. But not all multi-family real estate behaves uniformly, and some properties may be better inflation hedges than others. So how can you make sure you get the best inflation hedge you can possibly get?

The most important thing to remember is to remain disciplined around real estate fundamentals. This means investing in real estate that is well located and conservatively financed with long-term, fixed-rate debt. It also means having an understanding and awareness of market cycles and trying to invest in markets where new supply is limited in relation to current and future demand.

Under Supplied Markets Provide the Best Inflation Hedge

Supply is critical. You should be looking for markets that are undersupplied and deliveries of new apartments are constrained. Investing in an undersupplied market will ensure that you have the pricing power you’ll need in an inflationary environment. If you invest in a market that is oversupplied (think downtown office or big box retail), you will not have an effective inflation hedge because over supply typically leads to higher vacancy rates.  

Higher vacancy rates associated with imbalanced or oversupplied markets will eventually erode pricing power on rents. If you undertake an investment with higher vacancy rates, the risk of rent reductions due to vacancies will increase, and you will have an imperfect inflation hedge.

Extreme Example of an Over Supplied Market

In 2008, during the global financial crisis, 881 car dealerships were closed. The next year, in 2009, GM and Chrysler announced they would close 2,000 more dealerships on top of the 881 closed the year before. These skyrocketing vacancy rates during the financial crisis meant that the vast majority of these sites languished for several years. Obviously, this meant they were not generating any income at all, never mind income that could provide a hedge against inflation. In addition, car dealerships are also limited use properties, so redevelopment would require a significant amount of capital. If inflation had developed in response to the massive government stimulus that occurred in response to the crisis, this asset class would have been a very poor inflation hedge.

More on Inflation & Tight Supply

For those of you who prefer primary sources, as I do, this study by Wurtzebach, Mueller and Machi (circa 1991) takes an academic approach to explain what should be intuitive to all of all of us: commercial real estate is an effective hedge against inflation only if you invest in assets located in healthy markets with a clear path to increasing rents through property-level improvements.

If you invest in weaker, oversupplied markets (defined by Wurtzebach et al. as vacancy rates above 10%), or an asset with no value-add path, then high vacancy rates could make it impossible to raise rents, and you will be unable to combat inflation. As always, location is incredibly important, and no asset class or location is immune to imbalances, so you should also have an understanding of real estate cycles and risk. Real estate is inevitably cyclical, but if you are a long-term investor using long-term, fixed-rate debt, you will have a much easier time riding out the inevitable down cycles without loss of principle.

The Importance of Long-Term, Fixed-Rate Debt in Inflation Protection

Because real estate is a cyclical business, it’s extremely important to avoid the circumstance of being a forced seller. To protect against this risk, we are long-term investors, and we typically finance our assets with long-term, fixed-rate amortizing debt. Usually, this means debt with a 10-year term and 30-year amortization, but we have also financed assets with debt that is fully amortizing over 35 years.  Full amortization over 35-years means that the rents and cash flow are sufficient to pay distributions to investors and to fully pay down the debt to zero. Thus, at the end of 35 years, the asset is owned free and clear without any debt remaining.

Long-term, fixed-rate debt insulates investors from short-term interest rate fluctuations and higher costs associated with inflationary environments, and the amortization (payment of principal) is effectively insurance against any potential market weakness at maturity. For example, in 2023, we will be refinancing at least 2 mortgages, and while the market in 2023 will likely be choppy, we will be able to refinance quite easily. In addition, based on initial estimates, the refinancing proceeds will also be sufficient to return 100% of initial capital to investors, plus a substantial tax-free profit.

Apart from Inflation Protection, Remember That Real Estate Cycles Create Opportunity

The impact of inflation on the value of assets is one of the primary financial concerns of long-term investors, but the primary concern of long term investors is achieving above-market risk adjusted return on capital. Thankfully, real estate cycles provide regular opportunities to achieve above market risk adjusted returns, either by investing in strong markets that are temporarily over supplied, or by investing in weak markets with no new supply that are experiencing higher rates of household formation.

Money can be made at any point in the cycle, and in any market, so long as you have a keen awareness of market cycles, and you focus on minimizing your going-in basis.  Controlling your going-in basis is the single most important aspect of real estate investing in any cycle, regardless of inflation. Post closing, almost everything can be fixed but your basis. If your basis is flawed, you will have a very difficult time with almost everything else, including inflation protection.