Prices are rising at a rapid clip, and nowhere is this unfortunate reality more evident than at the pump. On June 14th, 2022, the national average price of a gallon of regular unleaded gas hit $5.01. This figure shattered the once-unimaginable five-dollar barrier and became the highest recorded gas price in American history.
But gas isn’t the only thing that’s getting expensive. To break it down, you’re now paying 10.1% more for food today than you were a year ago, 34.6% more for energy, 5.5% more for shelter, 7.1% for transportation, and the list goes on. Though the Fed agrees that a moderate inflation rate of 2% is healthy for the economy, most economists and policymakers concur that higher rates of “walking” inflation—annual price increases between 3% and 10%—are harmful to consumers, businesses, and investors.
But why is inflation so high?
While there is no single culprit for this phenomenon, at least part of this spike in prices can be attributed to the pent-up demand that was unleashed during the post-pandemic economic reopening. Due to the massive stimulus packages that were passed during the COVID-19 pandemic, Americans had $4.2 trillion in excess savings as we entered 2022.
When the economy picked back up, people had a lot of money to spend—which was a good thing until all the new money in the system fueled an oversupply of demand—leading to the high rates of inflation we observe today.
This is especially troubling when your income doesn’t keep pace with inflation. As the purchasing power of the dollar declines, you won’t be able to afford as many goods and services as you did previously.
That said, there are solutions to this conundrum. For instance, one of the most effective ways to protect yourself against rising prices is to own inflation-proof assets that can generate ever-increasing cash flows that match or exceed the rate of inflation. While inflation-indexed bonds are a possible candidate, real estate investments arguably provide the best hedge against inflation out of any asset class. Let’s find out why.
Real estate as an inflation hedge
There are several reasons why income-generating hard assets like real estate have the potential to serve as robust inflation hedges. For starters, rental income growth tends to keep pace with inflation—in part because a strong and inherent demand for shelter gives landlords the pricing power necessary to routinely raise rents.
In a similar vein, properties tend to appreciate in both nominal and real terms. Likewise, investors can benefit from the fact that inflation whittles away at liabilities like mortgages and other liens. Let’s take a more detailed look at each of these attributes to see how they protect real estate investors against inflation.
Upward pressure on rents
Real estate is first and foremost, a good inflation hedge because rents are easily adjustable. Most tenants living in single-family rental properties will sign annual or month-to-month leases, making it easy for investors and landlords to apply rent increases at the end of each lease period.
In fact, inflation may make this process even easier for landlords. Since inflation also leads to wage growth, tenants are left with larger nominal budgets (even if their purchasing power remains stagnant), and may tolerate more aggressive rent hikes than they would during periods of little or no inflation.
For this reason, inflation trends saw single-family home rents rise by 12.6% at the beginning of 2022. In addition, the national median asking rent climbed above $2,000 for the first time in history last month, and is likely headed higher from here.
Appreciating property values
The rate at which US real estate appreciates also keeps pace with inflation, making it a good shield against rising prices. This can be attributed to two factors: the appreciating value of land and the growing cost of improvements.
While the nuances surrounding the art and science of appraising raw land are difficult to understand, the reason why land holds its value (and often appreciates in real terms over the long run) is simple: land is scarce. In the words of Mark Twain, “Buy land, they ain’t making it anymore.”
However, the other half of real estate—the buildings, structures, and other improvements built on top of that land—also play a crucial role in inflation-proofing the asset class.
Specifically, while already-constructed improvements often depreciate over time, the replacement cost of those improvements—the cost to build a new, identical structure from scratch—typically increases as input costs rise over time.
This is evident in the current economy and housing market, where building material prices went up by 8% at the start of 2022. Partially as a result of this, the median home price increased to $428,700 in Q1 of 2022 from $369,800 in Q1 of 2021—a $58,900 or 15.9% jump.
As the costs of materials and labor go up, they make new and existing properties more expensive. Rising construction costs may also put brakes on the pace of new development, limiting the supply of the housing stock.
In May 2022, for example, new housing construction declined by 14.4%, the most since the beginning of the pandemic. This shortage of fresh inventory, coupled with steady or increasing demand, also puts upward pressure on the value of new and existing homes.
Inherent demand for rental housing
The third reason why real estate is inflation-proof is because of its intrinsic value. Shelter is a basic need, and people will always need a roof on their heads regardless of how the economy is faring.
And as the population increases, so will the demand for housing. This is reflected in the continuous rise in the US population, which grew by 0.57% in 2022 and nearly 6% in the last decade.
On top of that, interest rates are also soaring alongside inflation, causing the 30-year fixed-rate mortgages to rise above 6%. Due to the rapid rise in the cost of borrowing, prospective homeowners are putting off their purchasing ambitions. For instance, over 50% of millennials Americans say they are wary of homebuying due to debt.
This means that many will remain renters for the time being, pushing up the demand for rental property and providing property owners with an ever-growing pool of high-quality tenants.
Eroding mortgage burden
If you purchase your rental property using a fixed-rate mortgage, you’ll repay your lender the principal amount plus an interest rate that remains constant throughout the lifetime of the loan, which usually spans between five and 30 years.
In other words, you’ll make level monthly payments for the duration of the loan period regardless of the prevailing inflation rate. However, your rental income will keep growing in tandem with inflation. As a result, your debt effectively becomes easier to service as inflation increases.
On the contrary, if you buy a property with an adjustable-rate mortgage, you pay a low initial interest rate for a set number of years. When the introductory period elapses, your interest rate will fluctuate based on an underlying interest rate index. During inflationary periods, your adjustable-rate mortgage’s interest rate will rise considerably, and you’ll end up making heftier monthly mortgage payments.
For this reason, the vast majority of borrowers prefer fixed-rate home loans, and over 90% of mortgages outstanding today are of this variety. Let’s use an example to illustrate how a 30-year fixed-rate mortgage would work.
Beating inflation with a fixed-rate mortgage
Suppose you’re a first-time real estate investor. You buy a $250,000 house by borrowing 80% of the purchase price at an interest rate of 3.5%. Using a mortgage calculator, you determine that your monthly loan payments (principal and interest) will be approximately $900. These monthly payments remain fixed for the entire 30-year life of the loan.
Let’s see what your rents will look like if adjusted for a 3% annual inflation rate. To keep things simple, suppose you’re able to fetch a very respectable $2,000 per month in gross rents on your $250,000 property and that you incur no operating expenses.
Based on these rent and inflation rate inputs, your rent will grow from $2,000 to approximately $4,850 by the end of your mortgage loan. When you compare this amount with your monthly mortgage payment of just $900, you’ll wind up with substantial cash flows—especially towards the tail end of your loan’s term—all because your debt is fixed. The main assumption, of course, is that your operating expenses (which we didn’t factor into consideration here) also remain fixed at a given percentage of your gross income.
What about the value of your home? If we factor in the same 3% rate of appreciation on your quarter-million-dollar investment property, your home will be worth approximately $600,000 by the end of the loan period.
The takeaway?
While inflationary periods aren’t a fun time for most people, you can make the best out of your situation by purchasing assets that inflation-proof your income and wealth. And of all the choices out there, real estate investments are perhaps your best bet.