By Ee Hsin Kok. Edited by Swastik Patel
Over the last 10 years, inflation in the US has been less than 2% annually. Unfortunately, this is set to change. A combination of massive stimulus to the economy during the COVID-19 pandemic, global supply chain issues, and the Russia-Ukraine war has now led to inflation levels in the 8% range. As a real estate investor or someone hoping to buy an investment property or a REIT, you might be interested in how inflation might affect you, and that’s exactly what we’ll be covering today.
A Hedge Against Inflation
In theory, real estate should be able to hedge and possibly even capitalize on rising levels of inflation. Housing is an essential need for every person. We all need a place to stay, as it’s hard to sleep without a roof over our heads. Since inflation and wage growth are highly correlated, in periods of high inflation and therefore solid wage growth, tenants should be able to afford rent increases.
It should also be a similar case for commercial properties. As businesses increase the prices of the goods they sell, they will generate higher sales numbers and thus should be able to pay higher amounts of rent.
It’s Not That Simple
While real estate sounds like a great inflation hedge in theory, the reality is a lot more complicated than that. How a property performs depends on a multitude of factors, one of which is the type of property, and who the tenants are.
As an example, minimum wage workers have a large share of their income going toward expenses, and are unlikely to experience much wage growth even during periods of high inflation. Therefore a low-end apartment that rents out to them can’t raise rates to keep up with inflation, as their tenants simply can’t afford it.
Another example would be properties that are used as AirBnBs, vacation rentals, or are in areas that rely on tourism. The tourism industry usually gets hit pretty hard when inflation is high and as people decide to cut down on unnecessary expenses, these properties are likely to suffer.
Rising Rates and Possible Recession
A real estate investor also needs to consider the Federal Reserve’s reaction to high inflation. The Federal Reserve has already begun raising rates, which means mortgages have been getting more expensive, and therefore there’s less demand. This has already had an effect on the real estate market. While median home prices have still been going up, hitting a record high of $400,000+ recently, home sales have been decreasing consistently over the past few months, falling 3.4% in May.
With rates rising, there is also the possibility of a recession. The Federal Reserve does not want to induce a recession, but raising rates to slow down the economy may inevitably do exactly that. Albeit, this would be an artificially induced recession, different from the subprime mortgage crisis of 2009 that significantly crashed real estate prices.
Therefore, what a recession means for you is a bit of a short to medium term downside. Often consequences of a recession may include increased unemployment, economic contraction, and wage stagnation. This is worsened by the fact that the Federal Reserve can’t lower rates to stimulate the economy, as inflation is high. This would mean not only decreases in the number of house sales, but decreases in real estate prices as well. Of course, this could actually be a good thing. Similar to buying undervalued stocks in a bear market, real estate investors will be able to pick up properties for great prices in a prolonged down market. And when the economy inevitably rebounds, they’ll be able to make even more than before.
Real estate has been making new highs in recent years, and is a great hedge against inflation in theory. However, the performance of a property in an inflationary environment is highly dependent on the industry it is in. Additionally, the interest rate hikes coming to battle inflation will reduce demand in real estate, possibly induce a recession, and send prices lower. While this could mean a lot of pain in the short term, it could be a great opportunity to pick up undervalued properties that will yield great returns over the long run.