How Can Real Estate Hedge Against Inflation?
Real estate investments have historically served as a hedge against inflation over the long term. A key to its effectiveness lies in landlords’ ability to raise rents in markets with low vacancy rates, allowing them to outpace rising inflation and potentially increase income for investors.
At the same time, periods of high inflation typically lead the central bank to raise interest rates, which makes the cost of borrowing more expensive. Depending on what type of real estate investor you are and what type of real estate you invest in, the impact of inflation can vary.
What is Inflation?
Inflation is an increase in the general price of goods and services year-over-year. The Federal Reserve closely monitors the inflation rate and will make policy changes if inflation strays too far from the target rate of 2% annually.
Rising prices erode purchasing power for the everyday consumer, investors, and businesses, meaning the same dollar today will buy less in the future.
The US Bureau of Labor Statistics (BLS) measures the rate of inflation using the Consumer Price Index (CPI). This index uses a survey of households and calculates spending on a basket of goods and services.
What Is an Inflation Hedge?
Inflation hedges are investments meant to protect a portfolio from the effects of diminishing purchasing power. These hedges are typically assets expected to maintain or increase in value while inflation rises.
Hedging against inflation means taking steps to protect the value of an investment portfolio from the effects of inflation. Certain investments might seem to provide a decent return, but when inflation is factored in, sometimes they’re sold at a loss.
How Does Inflation Affect Real Estate?
Like every area of the economy, real estate prices rise during periods of high inflation. High housing prices can mean that would-be buyers have to continue renting. This means demand for rentals increases, because fewer people are becoming homebuyers. In turn, prices rise even more.
Inflation also makes the building of new homes more expensive due to the increased costs of building materials and a more expensive supply chain. This can lead to shortages in the housing market, which only pushes home prices higher.
The high cost of borrowing and the additional cost to build can make new construction very difficult in inflationary periods.
How Do Interest Rates Affect Real Estate?
Short-term inflation generally has little impact on mortgage rates and the real estate market as a whole. However, during periods of inflation above 2%, the Federal Reserve will typically step in to hike interest rates in order to make saving more attractive and borrowing more expensive.
When interest rates fall, the cost of borrowing decreases which leads many borrowers to refinance their homes at more favorable rates.
In today’s inflationary environment, the Fed has been raising interest rates more quickly and more steeply than in any other period of time since the 1960s. Higher interest rates lead to higher mortgage rates, which tends to prevent many individuals from being able to afford a new home.
In turn, this puts increased demand on rental properties, raising rent prices even higher.
Are Real Estate Investments an Inflation Hedge?
Inflation impacts the housing market in both positive and negative ways, and may depend on whether you are a homeowner, lender or investor.
People will always need somewhere to live, which means there will always be a demand for rental properties, regardless of the economic environment.
During high inflation periods, that demand is only heightened as fewer people are able to pay higher down payments and mortgage payments.
Pass-Through Inflation Costs
Inflation increases not only property values but also electricity, gas, water and other essentials. As a rental property owner, the burden of price hikes can easily be passed through to your renters. If your renters are paying at a rate that outpaces inflation, you’ll be able to hedge against inflation.
Control Over Your Investment
When you invest in real estate, you may have some control over your investment compared to other asset classes. For example, you typically have a choice in who can rent your units, how much you charge for rent, and even when you want to sell your investment.
Types of Real Estate Investments
Real estate investments offer a couple of advantages during inflationary periods, but not every real estate investment will provide the same level of protection.
- Rental properties, including residential and commercial real estate, multifamily and single-family homes will likely have heightened demand, leading to higher prices. As an investor in rental properties, the increased costs lead to increased returns.
- Real Estate Investment Trusts (REITs) tend to follow the market demands and appreciation similar to that of physical real estate and can be an easy way to distribute your investment across a large number of assets without purchasing multiple properties.
The Bottom Line
Real estate is considered one of the best inflation hedges by economists for its stability and cash flow while stock markets experience volatility. The consistent demand for housing along with the ability to pass through higher prices to the renter means real estate investors tend to benefit from high inflation, but there’s no guarantee.
While there are many benefits to real estate investing, which can be particularly amplified in inflationary periods, it’s important to know what your objectives and risk tolerance are and design a strategy that suits your particular situation.
This material is provided for informational and educational purposes only. It is not intended to be investment advice and should not be relied on to form the basis of an investment decision