“Real estate is a hedge against inflation,” a phrase spoken with the same conviction that Sir Isaac Newtown said, “…what goes up must come down.” (Excluding real estate, of course.) For the record, salt and gold are also a hedge against inflation, and they are a lot easier to own so long as you are not storing them under your mattress. And yet, real estate promoters love to speak of the mythical real estate hedge that protects investors from inflation like shields on The Starship Enterprise, all the while soaring to new heights in value.
While it is true that real estate possesses specific characteristics that, when combined correctly, can outperform during periods of inflation, it is not true that all real estate outperforms during inflationary periods, and some of it does quite badly.
They Aren’t Making More of It
There is a finite amount of land, even less so that is developable, and an even smaller amount with high-quality improvements. It takes years to develop new buildings, so supply reacts slowly to changes in demand. When inflation erodes the purchasing power of cash, making each $1 worth less, investments in assets with limited supply tend to do better. They rise in value with inflation. In this sense, real estate behaves a bit like a commodity.
In addition to the finite amount of land on the planet, property is almost always a vital economic input. Being a platform for other businesses is another characteristic it shares with commodities. Land is needed to farm, warehouses are needed to store products from the farms, and offices and retail stores are needed to provide the infrastructure for the markets where those products trade. People need roofs to sleep under. And in the 21st century data centers are needed to store pixels and bytes. These qualities create long-term, consistent demand for real estate, which is more than we can say for tulips in 1637 or crypto yesterday.
Problems occur when there is too much supply. Markets have a nasty habit of building more of everything than what is needed when times are good, and when times are bad, supply exceeds demand. The oversupply is often temporary; demand catches up, and the market balances. Although temporary, market equilibrium can take a very long time; temporary does not mean brief. If an investment has not established a durable income stream before the market overbuilds, that real estate will suffer inflation like a pair of concrete boots at the end of the pier and temporary will feel like drowning.
As I have said, limited supply and a vital economic input are not unique to real estate. This is basically the definition of a commodity, and there are plenty of commodities in the world.
Secret Weapon
Unlike a commodity, real estate produces cash flow. Gold and salt can be exchanged for cash when there is demand, but the cost to store them may outstrip the appreciation during the lean times. The right real estate generates cash. There is little downside to holding a cash-flowing property during periods of inflation. Operating cash covers expenses; it can be used to improve the property, acquire new tenants, or amortize debt, and if you’re lucky, a little mailbox money will come your way at the end of the day. Cash flow is an excellent quality in any market. Still, it is precious during periods of inflation when investment demand may dip, and holding onto a simple commodity increases your basis but does nothing to provide a return in the interim. In this case, cash-flowing real estate is far superior to most basic commodities.
Cash flow is excellent, but an asset’s net cash flow is still at the mercy of costs, which rise during periods of inflation. Wages, materials, taxes, and insurance all increase with inflation. Fortunately, most real estate revenue structures allow them to reset periodically to adjust for inflation and demand. Typically, these rental increases are contractual and require little, if any, additional investment on behalf of the owner. Of course, new tenants and renewals have some revenue acquisition costs. The key here is managing that exposure so you are not replacing every tenant simultaneously. That’s going to be ugly.
In addition to operating costs, interest rates, which are the cost of debt, have a very tight correlation to inflation and will rise with it. Interest rates are significant because debt is a crucial input to most real estate investment returns, and its cost is usually one of the most significant investment expenses. During periods of inflation, floating rate debt, loans with interest rates that reset to market periodically, can bury an investment if revenue is not growing at the same rate. And debt that needs to be refinanced at the wrong time is just as bad or worse. Not only does your borrowing cost increase, but debt may not be present. Bueller….Bueller…..Bueller, did somebody say office loan?
The Fix
Long-term fixed debt. If there is a secret ingredient to using real estate to protect your capital against inflation, that’s it. The ability to fix your cost of borrowing for periods of five, ten, and even forty years is a significant tool in the fight against inflation and is typically very accessible to real estate. As I said, cash flow is excellent, and rising cash flow is even better; add fixed costs to the mix, and you get improving margins. And that is as good as it gets.
Now, this is only relevant if your investment is leveraged, but most real estate investments are. Sponsors bring debt to the capital stack at a lower rate of return to the equity, and the profits from improved income flow to the investors. When you have floating rate debt, any revenue increases will almost certainly be eaten up by rising interest rates. When the interest an investment is paying on its debt is below the market cost of the debt, you have a hedge against inflation.
Debt, of course, is a double-edged sword. It might even have a third edge. Enough debt will increase equity returns materially. More debt increases risk. In a spreadsheet, the more debt you have, the better the equity return looks, so managers and investors tend to lay it on pretty thick. The risk is that when asset value declines, those losses hit the equity first, and if you have too much debt, those declines wipe out the equity. There is a big difference between losing 10% of your equity and still owning the asset and losing 100% of your equity. Lenders don’t typically let you retain ownership after all the equity is gone. If you have a good asset that is not overleveraged, the investor lives to fight another day and maybe even recover those losses.
A spoonful of leverage helps the equity returns go up, and too much leads to obesity, diabetes, and early death.
If
If you own the right real estate, you own a commodity. If you know what you’re doing with that real estate, it generates revenue. And if you understand finance, you can fix your interest expense over a long period of time and increase margins. So, if – if – if, and yes, real estate protects your investment against inflation better than other types of assets. However, you can miss the mark on any one or, god forbid, all of these, and real estate is no better a hedge against inflation than that $1 in your bank account. In fact, it is worse. Your cost basis will increase as the value declines, and you will quickly get into trouble. And all of a sudden, the hedge is getting sheared.
Many investors have not experienced a period of inflation like we just saw over the last three years. Hopefully, lessons were learned. Now, with the real estate market down, the intelligent investor is ready to jump back in.
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