Inflation leads to the rise in the prices of goods and services. This is clearly not ideal for the average consumer. Inflation is a concerning issue because when it rises, that means the money you save today will be worth less tomorrow. This economic occurrence that erodes one’s purchasing power can have an impact on savings, and your ability to secure a stable retirement. This is why it’s important to understand what hedging against inflation is, and how you can do it in order to secure your financial future.
What is Inflation?
Inflation is the rate at which prices for goods and services rise, according to Investopedia. Inflation results in a decline in purchasing power. While inflation means that consumers can buy less goods and services with the money in their pockets, for investors who own assets, inflation results in a rise in the price of their assets.
Before we get into how inflation impacts multifamily real estate, let’s define the different types of inflation.
Cost-push inflation happens when businesses, in response to an increase in the cost of producing their goods and services, increase the price consumers must pay for those goods and services. Companies need to pay for the materials and labor that go into providing consumers with goods and services, and as the price of things like steel, oil, lumber, and labor go up, this can result in companies having to raise prices in order to still make a good profit.
Demand-Inflation occurs when the demand for a certain good surpasses the supply chain’s ability to provide enough supply to meet it. This type of inflation tends to happen when consumers have an increase in discretionary income that allows them to be able to afford higher prices for the same goods and services. This can also occur when the government prints more money and injects it into the economy. As consumers have access to more money, prices rise to mitigate the sudden rise in demand for goods and services. As a result, consumers lose purchasing power.
Built-in Inflation is a result of a change in the labor force expectation. Members of the labor force expect inflation to continue to rise, and as the price of the goods and services they pay for increase, they begin to demand higher wages in order to keep their standard of living. This labor cost increase results in the increase in the cost of goods and services, resulting in a cycle of inflation.
As reported by the U.S. Inflation Calculator, the yearly inflation rate was 8.5% as of July 2022. Prior to this, it was at 9.1%, and U.S. Labor Department data shows this was the highest it’s been since November 1981.
What is Inflation Hedging?
An inflation-hedging asset is an asset that preserves the purchasing power of a currency that would otherwise decrease as a result of a loss of value due to inflation. Inflation hedging allows an investor to mitigate the decrease in a currency’s value that results from inflation. This protects the decreased purchasing power, and the value of the investment itself. Savvy investors plan for inflation by investing in asset classes that outperform the market during inflationary periods, such as multifamily real estate.
There is risk involved in nearly every investment, and inflation is a major one that investors need to pay attention to. Hedging against inflation allows investors to protect their hard earned capital and preserve their wealth. This is why it is essential that every investor include inflation-hedging in their wealth building and protection strategy. A great way to hedge against inflation is to invest in assets whose values are linked to inflation. As inflation increases, the value of these assets also increases.
Why Multifamily Acts as a Hedge Against Inflation
Demand for multifamily real estate has remained strong throughout the COVID-19 pandemic. The historical track record of the asset class shows that multifamily is capable of surviving times of inflation and economic downturns. Multifamily is essential, because people will always need a roof over their heads. Even when cutting costs, their place of residence will be a priority for consumers.
During times of economic hardship, demand for rentals increase as mortgages become harder to obtain. This means that even those who want to buy a home won’t be able to afford one, and are more likely to rent an apartment unit as a result. This only adds to the demand for apartments.
Rental Rate Increases
When the cost of construction increases as a result of inflation, this typically leads to a decline in the construction rate of new apartments. This adds even more demand for existing units, which allows apartment owners to increase rents. With the combination of increasing interest rates and a supply shortage, the possibility of owning a home is becoming increasingly more unattainable for the average American. This means that there is more demand for the same amount of apartment units, which also allows apartments to increase rents. Since multifamily leases are typically 6-12 months, apartment owners can implement rental increases on a regular basis. Due to the short-term leases, regular rental increases allow apartment owners to mitigate the impact of inflation.
As time passes, it’s common for apartment buildings to naturally increase in value over time. Due to multiple factors that we’ve already discussed, multifamily properties are a scarce resource that everybody wants. The benefit of increasing demand for these properties is that rental rates increase as well. This allows apartment owners and investors to keep up with the rate at which expense prices are increasing, and this allows multifamily real estate to act as a hedge against rising prices.
The tax benefits of investing in multifamily real estate can help investors mitigate the increase in expenses. There is a wide range of tax deductions multifamily investors can take advantage of. This includes deductions on property taxes, insurance, operating costs, travel and mileage expenses, closing costs, depreciation, and more. Please consult with your tax advisor in order to get more information on how to take advantage of the applicable deductions you may qualify for.
Downsides to Multifamily Investing During Inflationary Periods
Investing in multifamily real estate is not without its obstacles, particularly during a time where inflation is high. When the prices of goods and services are increasing, operators must focus on generating a strong cash flow and controlling their expenses.
Increase in expense costs
As we've discussed, the cost of goods and services includes the labor and materials needed for construction and renovations. Seeing as how value-add investors typically include some form of remodeling or renovations into their business plan, this increase in prices can throw a major wrench in their project. Some operators may decide to not do certain projects, especially if they aren’t necessary and are mainly for cosmetic purposes. A cosmetic renovation may cost more than the increase in rent they will justify. It’s important to keep expenses low during inflationary periods because existing and essential expenses are likely to increase. Because of this, savvy operators keep a surplus of “dry powder” in order to plan for anything that unforeseen repairs, updates, or other renovation projects that might affect occupancy and rents.
Changes or Delays in Construction
When prices increase, operators may choose to put off certain projects. This can delay, or completely change a business plan. The business plan, especially for value-add investors, is the blueprint an operator will use in order to improve the property and generate their projected returns for their investors. Increased costs do not make it impossible to implement a business plan, but it is important for operators to account for the potential increase in costs in their underwriting and have enough cash reserves so the property can still perform during difficult times, and so the business plan is still able to achieve projected returns.
Increase Debt Costs
In recent years, multifamily investors have benefited from inexpensive, fixed rate debt. This has allowed more investors to be able to afford apartment properties. As a result of this higher demand, prices for multifamily properties have increased. The favorable debt terms also allowed investors to finance the renovations and improvements included in their business plan at a decreased price, which allowed operators to add more overall value to the property. During inflationary periods, the cost of debt increases drastically. The cost of multifamily investing and financing the improvements of multifamily properties increases as a result.
How Conservative Underwriting Can Mitigate the Impact of Inflation in Multifamily
Conservative underwriting is a key way for operators to mitigate the impacts of inflation. Understanding how realistic an operator’s business plan is will help you determine how viable the project is during an inflationary period. This is a good time to re-emphasize the point that multifamily properties benefit from higher inflation. The less people that can afford a mortgage to buy a house expands the renter pool, which increases demand for apartment units.
The issue of increasing costs can be resolved if an operator successfully manages their cash flow. They might want to postpone any projects that aren’t necessary and don’t have a direct impact on their bottom line. Operators can also maximize opportunities by renegotiating contracts with their vendors in order to account for changes in prices caused by inflation.
Regardless of whether or not inflation continues to rise, strengthening your investment portfolio so it is protected from the impacts of inflation is key to building and protecting your wealth. It isn’t enough to just invest. Investing with a mindset involving longevity and endurance will ensure that the hard work you put into creating and building your wealth is not in vain. Investing in an inflation-hedging asset class like multifamily apartments ensures that your wealth lasts, regardless of tumultuous and unpredictable external factors like inflation.