Following my previous blog in Part I of this series, several of our clients have requested that we provide more information on investing in real estate during extended inflationary periods. In this blog post, we’ll revisit several basic concepts and then take a deeper dive into what we have learned about real estate and inflation.
How Today’s Inflation is Impacting Investment Decisions
With each passing month, it is becoming clearer that today’s elevated inflation rates are likely to be with us for some time. The combination of high government stimulus during the pandemic plus persistently high energy prices has fueled price increases that we have not seen for 40 years.
At the first signs of growing month-to-month price increases that we experienced in early 2021, most of our investors wisely decided to stand pat and see if the emerging trends were temporary – or more likely to persist over time.
The past year of steadily growing increases is now clearly beginning to impact investment decisions as investors become more anxious over how to best protect their investment capital.
Here is what we are seeing:
Rotation Into More Inflation Resilient Asset Classes
Those of us who lived through the 70’s recall that we experienced heightened inflation that persisted for almost a dozen years. During that period, we saw many investors moving equity into so-called hard assets including gold and other commodities, as well as into real estate. Then, as now, we are seeing a greater shift of investment funds into real estate asset classes that offer greater flexibility to investors to raise rents to keep pace with general price increases – and lesser amounts of funds going into assets that have inherent limitations on rent increases that can be passed onto tenants.
Asset classes including apartments, storage, senior housing, student housing, and hotels that have relatively short-term leases offer investors the greatest ability to raise rents to match market conditions. In contrast, asset classes including retail, commercial, heath care, and others with longer term leases, limit investors’ ability to raise rents due to annual rent caps present in most long-term leases.
For example, in areas not impacted by rent control, we have seen apartment rents increase by double-digit rates this year (2022) in many growing areas across the US.1
In contrast, based on properties we have directly managed for investors who own retail and commercial properties governed by long-term leases, we see annual rent cap of not more than 1% to 3%.2
What Happens When Rental Rate Increases Lag General Price Increases?
At time of sale, the value of rental properties is highly correlated to the amount of income generated by the property relative to other similar properties in the submarket. If investors are not able to raise rental rates and income during their holding period relative to other comparable properties, there is a higher risk that will not be able to fully recover their original investment when the property is sold.
We are talking to a growing number of investors who are now moving away from assets with annual rent caps and into those, such as apartments, where rents can be more rapidly increased in order to better protect a potential loss of investment capital.
If High Inflation Persists, What Other Changes Can Investors Expect?
The US has of course experienced past periods of extended high inflation and it is instructive to note some of the future trends that we are likely to see if the current rate of price increases does not moderate.
Residential mortgage rates have risen by 1.5% since the beginning of the year due to Federal Reserve actions to cool rising prices.3 Lending rates for rental properties are also under upward pressure. We can expect further rate hikes by the Federal Reserve to continue to push up lending rates – which may negatively impact the economics of investing in real estate.
To the degree that inflation remains high and difficult to predict, investors should also expect to a see a return of the dreaded variable rate mortgages that were common in other inflationary periods. Should we experience higher uncertainty over future inflation trends, lenders will be less willing to lend money at fixed interest rates.
And today’s still historically low interest rates may seem like a bargain compared to what may lie ahead.
Changes in Commercial Lease Terms
Should elevated inflation persist, investors will no longer tolerate providing tenants with leases containing not-to-exceed annual rent caps. Adjustable rents will become more prevalent and, as in times past, be tied to government issued price change indicators such as the Consumer Price Index (CPI). Such moves are likely to restore investor interest in retail and commercial investment properties and allow rental income for these types of assets to better adjust to changing market conditions.
For additional assistance on navigating your real estate investments through today’s many challenges, please contact us by phone at 866 398-1031 or via email at info@FGG1031.com. You can also book a free consultation with me here.