Real estate investors spend enormous amounts of time analyzing rents, occupancy, property taxes, insurance, location, and local supply and demand. But one of the greatest risks to real estate returns can originate far from the property itself: the monetary system.
Public discussion of inflation often focuses on its immediate causes—oil prices, supply-chain disruptions, housing shortages, tariffs or rising wages. These factors certainly affect individual prices and can temporarily increase measured inflation.
But persistent, economy-wide inflation raises a more fundamental question: Why is the dollar's purchasing power declining?
For real estate investors, this matters enormously because sustained inflation and the monetary response to it can affect virtually every component of an investment: interest rates, financing costs, capitalization rates, property values, replacement costs, rents and investor distributions.
Creating more money does not, by itself, make society wealthier.
If another trillion dollars were created tomorrow, America would have more dollars—but it would not suddenly have another trillion dollars of houses, apartment buildings, factories, food, energy or other productive assets.
Money is a claim on wealth. It is not wealth itself.
Real wealth comes from productivity, investment, innovation, entrepreneurship and the production of goods and services.
The individual states illustrate this distinction. California, Texas and Florida cannot print dollars, yet their economies can grow and create enormous amounts of wealth. Economic growth does not require state governments to manufacture money.
Monetary expansion can initially make credit plentiful and interest rates relatively inexpensive. This can stimulate borrowing, consumption, investment and asset prices, including real estate.
But if money, credit and overall spending grow persistently faster than the economy's ability to produce goods and services, inflationary pressure can develop.
The Federal Reserve then frequently responds by raising interest rates. Higher rates reduce borrowing and spending, suppressing demand and helping bring inflation down. But higher rates do not themselves create more goods, services or productive capacity.
If excessive monetary and credit expansion subsequently resumes, inflationary pressures can return.
Monetary expansion → inexpensive credit → inflation → higher interest rates → more expensive financing and pressure on real estate values.
Real estate investors commonly value income-producing property using a capitalization rate, or cap rate. A cap rate is simply a property's annual Net Operating Income divided by its value. In plain English, it represents the property's income yield before financing. Cap rates and interest rates are not the same thing, and they do not necessarily move together. But they are related.
When interest rates are very low, investors may accept relatively low yields on real estate. When interest rates rise and relatively safe bonds offer higher returns, real estate investors generally require sufficient additional return to compensate for property risk and illiquidity.
That can put upward pressure on cap rates. And because higher cap rates generally mean lower property values for the same amount of income, rising interest rates can put downward pressure on real estate prices.
For leveraged properties, the effect can be compounded. Financing becomes more expensive at the same time that the property's market value may be under pressure.
This is why variable-rate debt, excessive leverage and near-term refinancing requirements can be particularly dangerous during inflationary periods.
There is another side to the story. Well-selected real estate has the potential to provide meaningful protection during sustained inflation.
Unlike dollars, real estate is a tangible asset that cannot simply be created by monetary policy.
Inflation generally increases the cost of land, labor, construction materials and replacement buildings. Rising replacement costs can support the value of existing properties by making competing new construction more expensive.
Many properties may also be able to increase rents over time. As rents rise, Net Operating Income can rise as well, providing investors with an income stream that may adjust at least partially to inflation.
This is particularly valuable when a property has little or no exposure to variable-rate debt.
A property financed with long-term fixed-rate debt may actually benefit from inflation because the loan remains fixed in nominal dollars while rents and property values may increase over time. A property with little or no debt avoids much of the interest-rate risk altogether.
Inflation may benefit the underlying real asset while simultaneously damaging an overly leveraged capital structure.
During periods of elevated inflation, investors should place particular emphasis on properties with low or moderate leverage, minimal variable-rate debt exposure, durable tenant demand, the ability to increase rents, healthy operating margins and conservative refinancing assumptions.
Under those circumstances, inflation reinforce some of the traditional advantages of real estate ownership.
Cash loses purchasing power during inflation. Many fixed nominal investments can lose purchasing power as well. But productive real estate may be able to generate income, adjust rents, benefit from rising replacement costs and retain intrinsic utility regardless of the number of dollars in circulation.
That is an important reason real estate has historically been viewed as a potential inflation hedge.
The key qualification is leverage.
Real estate with excessive or variable-rate debt can be highly vulnerable to the higher interest rates that frequently accompany inflation. Real estate with conservative leverage, fixed-rate financing or no debt may be positioned very differently.
For investors concerned about continuing monetary expansion and declining purchasing power, the objective should therefore not necessarily be to avoid real estate. It should be to own high-quality real assets with durable income and limited exposure to the very interest-rate cycle that inflation can produce.
For further information on those investments most likely to an inflation hedge, please contact the professionals at First Guardian Group/FGG1031. You can contact us at 866 398-1031 toll-free or via email at info@FGG1031.com.