During the last two months there has been a significant increase in both the Consumer Price Index (CPI) and Producer Price Index (PPI) which measure price changes in select goods and services that have raised heightened inflation concerns from many of our clients.
What is behind the recent surge in reported price indices and what should real estate investors consider in making future investments?
Which Causes of Inflation Most Concern Investors?
Increases in prices of goods and services can come about in different ways, some of which are of lesser concern when considering strategic investments. In some cases, prices can spike because of supply and demand imbalances. Think about the time when you tried to buy tickets to a popular event and saw prices soar due to high demand. Temporary supply and demand imbalances which exist for limited periods typically do not significantly impact long-term investment strategies.
Of greater concern however are systemic price increases that impact a wide range of goods and services which are chiefly caused by changes in the money supply which cheapen the value of the dollar over time, also called monetary inflation.
Most policy makers believe that an acceptable annual inflation rate of around 2% is acceptable and would not cause investors to dramatically shift investment strategies. However when monetary inflation appears to head higher over an extended period, we see shifts in the types of investments that are viewed to be attractive.
Impact of Increasing Inflation on Real Estate
My first real estate investments were made during the 1970’s when inflation was raging, approaching almost 15% by the end of the decade. While interest rates were pushed higher as well, astute real estate investors were still able to make good investments through modifying their investment strategies. What did we learn then that may be applicable should we now be entering an extended inflationary period?
1. Shift investments into assets whose income and value that can keep pace with generally rising prices.
Residential assets in growing, economically strong areas trend to perform the best during heightened inflationary cycles since rents can more be easily raised.
Owners of properties with fixed term leases such commercial offices, retail, medical, etc. will be limited to adjusting rents per what is allowed in their lease agreements. Since we have experienced relatively low rates of inflation over the past 10 years, most fixed term leases in effect today limit annual rent adjustments to 2% or less. Since rental income is a major factor in determining the value of an asset, the inability to boost rents to match higher inflation rates can lead to a loss of value in these types of assets.
2. Consider using fixed rate loans to partially finance purchase of properties.
During periods of rising prices, use of fixed rate loans will allow investors to repay their loans with cheaper dollars. The Federal Reserve has indicated that they plan to hold interest rates near current levels for at least the next 12 to 18 months which will allow the prudent use of debt to help boost returns.
3. Stay ahead of the curve.
In the early days of a spurt in inflation, institutions and individuals tend to react slowly to make changes in how they operate. Savvy investors will tend to load up on fixed interest debt and complete contracts and purchases with fixed price terms. Once higher rates of inflationary become the norm, contract terms will change to allow adjustments based on inflation rate indicators. Recall how loans in periods of higher inflation shift to variable rates tied to indexes that monitor inflation such as LIBOR or the federal funds rate.
4. Move cash into inflation protected near liquid alternatives.
Inflation creates heightened uncertainty which causes many investors to allocate more of their net worth to relatively more liquid assets such as cash or cash equivalents. Since cash will decline in value and lose purchasing power in times of inflation i.e., informed investors will tend to convert cash into assets such as Treasury Protected Inflation Securities (TIPS) and publicly traded stocks or ETFs that invest in hard assets such precious metals that can keep pace with inflation while providing good liquidity in case a sudden need for cash occurs. More adventurous investors may consider shifting some cash into digital currencies such as Bitcoin which also provide a degree of liquidity – albeit with higher volatility.
Summary
It is not likely that the federal government will default on its debt or be able to significantly reduce our growing deficits by solely raising taxes. The most common solution to mounting debt obligations as we saw in the 1970s is to repay debt with cheap dollars.
Given the options of repaying debt with added taxation versus printing more money – history tells us that most politicians favor cheapening currencies rather than pushing for unpopular tax increases.
With our rapidly growing deficits and spending plans, a higher rate of inflation ahead appears inevitable. History tells that one of the best ways to fight and maybe beat inflation is to shift investments into those assets that perform best during inflationary period such as residential and multifamily real estate – while also shifting some cash into relatively liquid inflation hedged options such TIPs and precious metal equities.
For more information on real estate investments that may provide a hedge to inflation, please contact us at 408-392-8822 or info@FirstGuardianGroup.com.
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References:
1 https://www.bls.gov/cpi/ and https://www.bls.gov/ppi/
2 https://www.federalreserve.gov/faqs/5D58E72F066A4DBDA80BBA659C55F774.htm
3 https://www.longtermtrends.net/m2-money-supply-vs-inflation/
4 https://www.investopedia.com/terms/v/variableinterestrate.asp
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