How to Use Real Estate as a Hedge Against Inflation
In 1964 inflation was a little over 1%, about where it had been for the preceding several years. Throughout the mid-1960s inflation gradually began to increase to an annual inflation rate of more than 14% in 1980.
Many investors today are wondering if the same increase in inflation that occurred two generations ago could happen again. In this article, we’ll discuss the affect that inflation has on prices and real purchasing power and explain how to use real estate as a hedge against inflation.
What is Inflation?
Inflation is the creeping increase in prices and the slow but steady decline in purchasing power over a period of time. Rising inflation occurs so slowly that most people do not even realize they are getting less bang for their buck, so to speak.
Three of the main ways the government and investors measure inflation in the U.S. are the Producer Price Index (PPI), the Personal Consumption Expenditures Price Index (PCE), and the Consumer Price Index (CPI).
According to the most recent CPI (April 2021), urban consumer prices rose by 0.8% for the month and increased by 4.2% over the last 12 months. The U.S. Bureau of Labor Statistics (BLS) reports that since 1982 the consumer price index for urban consumers has increased by about 167%.
That’s another way of saying that purchasing power has declined by more than half over the past 40 years alone.
What to do When Purchasing Power Goes Down
Assuming inflation stays at about 4% per year, one dollar will be worth $0.96 cents next year, $0.92 cents the following year, $0.88 cents the year after that, ad infinitum.
When purchasing power begins to decline, as it has been for quite some time, investors look for assets that act as a hedge against inflation. Inflation-oriented assets are those that provide income, appreciation, or ideally a combination of both to offset the on-going decline in purchasing power.
There are five categories of assets that historically act as a hedge against inflation:
US Treasury Inflation Protected Securities (TIPS) are an extremely safe way for very conservative investors to hedge against inflation. Unlike most bonds, the interest payments investors receive are indexed to the rate of inflation. As inflation rises interest payments also go up, and vice versa. One of the problems in using TIPS as an inflation hedge is that the government tells the investor what the rate of inflation is, rather than price signals in the real world.
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Defensive stocks are those that generate consistent earnings through various business cycles, such as consumer goods, energy, and technology companies. They can provide a good hedge against inflation, provided that price increases can be passed through to consumers.
As companies become more profitable, share prices also rise. For example, growth stocks such as Shopify, Alibaba, Facebook, Netflix, and Amazon have all posted compound annual growth rates (CAGRs) of between 28% and 183% over the past three years.
However, if interest rates begin to rise along with inflation, borrowing costs also increase, which in turn puts downward pressure on CAGR and stock prices. The stock market as a whole can also be volatile, with share prices increasing one day due to bullish good news, and falling a few days later if traders become bearish and begin driving prices down.
Commodities are assets such as natural resources, raw materials, agricultural products. Prices of commodities usually increase when inflation is high, as is occurring today with lumber and copper prices. Gold and silver throughout history have been viewed as having intrinsic worth, unlike most fiat currencies.
Energy commodities such as oil and gas are also used as inflation hedges, because prices can be passed through to businesses and consumers who depend on energy to run manufacturing facilities and heat homes.
Back in 2010, a single Bitcoin was valued at $0.08. Today, the value of one Bitcoin is about $33,000 (CoinDesk June 2021), representing a price increase of over 412,000% over the past ten years. To be sure, cryptocurrencies are relatively new and were not in existence during periods of high inflation such as the 1970s, so it is unknown how they will continue to perform.
Perhaps to hedge their bets against both rising inflation and for the widespread adoption of cryptocurrencies, companies such as MicroStrategy, PayPal, and Square have allocated a portion of their corporate treasuries away from cash and into Bitcoin.
Real estate includes raw land, residential and commercial properties, and real estate investment trusts (REITs), and is an asset whose value historically increases faster than the rate of inflation.
According to the Federal Reserve Bank of St. Louis, the median sale price of houses sold in the U.S. has increased from $63,700 in 1980 to $347,500 in Q1 2021, a change of nearly 550%.
Unlike stocks, bonds, paper gold and silver, and electronic cryptos, real estate is an asset that generates recurring income streams and an increase in asset value over a long-term holding period. For these reasons, real estate is often referred to as a “hard asset.”
What is a Hard Asset?
A hard asset is a resource or tangible asset with intrinsic, fundamental value that is normally held as a long-term investment.
Hard assets generally serve as a hedge against inflation and have values that change inversely to soft assets such as cash, stocks, and bonds. Examples of hard assets include commodities, paintings and collectibles, energy resources, precious metals, and real estate.
Characteristics of hard asset investments
- Attractive to investors due to being physical and tangible, qualities that most other investments do not offer.
- Hard assets are used to diversify a traditional portfolio of stocks, bonds, and cash.
- High correlation with inflation makes hard assets an excellent hedge against inflation.
- Low correlation with more highly volatile traditional stocks and bonds, adding value to a diversified portfolio.
- Hard asset prices do not have to be monitored daily or even hourly, because the prices of assets with fundamental value do not vary based on the evening news.
- Because hard assets are illiquid and can not be quickly traded, prices of hard assets remain relatively stable compared to some stocks that may decline in value by 20% or more in a single day.
Why Real Estate is a Hard Asset
Developed real estate is comprised of two distinct hard assets:
- Land or lot the property is erected on
- Building or structure itself
These two components that make real estate a hard asset are also directly related to two of the main benefits of investing in real estate: Recurring income, and appreciation in asset value over the long term.
With investment real estate, entire buildings or space that is leased to tenants generate monthly rental income and cash flow, while both the land and building can appreciate in value over time.
The IRS also views investment real estate as a hard asset. Investors are allowed to depreciate a commercial building over a period of 39 years, because the IRS assumes the building eventually wears out, at least for tax purposes. On the other hand, land is not depreciated because it lasts forever.
However, when the property is sold, the building depreciation expense taken by the investor is recaptured and taxed as regular income by the IRS, which means that the building doesn’t actually wear out, provided that it is properly maintained. In fact, the replacement cost of buildings and structures generally increases over time, due to the impact that inflation has on the cost of labor, supplies, and raw materials.
Land is Limited
There are plenty of well-known quotes about land from people who became very wealthy by investing in real estate. John D. Rockefeller said that the “major fortunes in America have been made in land”, while Mark Twain advised readers to “Buy land, they’re not making it anymore.”
Investors who own land benefit from the basic economic principle of scarcity, which refers to the limited supply of land and the limitless wants and needs for land.
Of course, just because land is limited, common sense says that land does not have the same value wherever you go. For example, there’s a big difference between the value of land in the middle of the Sahara desert that does not have oil or water underneath compared to land zoned for self-storage development in Florida or South Carolina.
Inflation and Changes in Values
The value of real property changes based on inflation and the decline in the value of fiat currencies.
When goods, services, and the cost of living in general increasingly become more expensive due to inflation and rising demand, investors view real estate as a way of preserving capital. As we discussed earlier in this article, when the dollar becomes worth less and less as the years progress, people invest in real estate to offset the insidious effect of monetary debasement.
When an economy is growing rapidly, companies raise their prices because the cost of materials and wages rise due to increased demand. Hard assets such as real estate are also positively affected by economic growth as more businesses start up and expand. During an economic contraction, the self-storage industry also benefits as businesses and consumers downsize and store equipment and personal belongings until the recession comes to an end.
Monetary debasement occurs when governments print more money, as is occurring today in many countries around the world, including the United States. The Federal Reserve’s balance sheet has more than doubled in size in the past two years alone, growing from about $3.9 trillion dollars in May of 2019 to $7.9 trillion in May of 2021. Monetary debasement and inflation are synonymous with one another because there is more money to spend on scarce assets such as real estate the more prices rise over time.
If purchasing power kept pace with the rate of inflation, then inflation in and of itself might not be so bad. Unfortunately, the opposite happens, and the only way to fight inflation is to make more money, which is why an overwhelming number of investors turn to real estate.
Real estate values historically increase over time, generally outpacing the annual increase in inflation. According to the Green Street Commercial Property Price Index, the weighted value of all types of commercial real estate – including retail, office, multifamily, and self-storage – has increased by 180% over the past 20 years.
Income generated from rental real estate pays for operating expenses with the remaining profit flowing through to the investor. When inflation causes expenses to increase, landlords can raise the rents to cover the increased cost of doing business. In the self-storage industry, the majority of leases are month-to-month, allowing ownership to quickly react to inflation by increasing rents.
A third way investors use real estate to fight inflation is with debt depreciation. For example, assume the monthly debt service on a commercial property is $10,000 per month. If the current 4% rate of inflation remains unchanged, five years from now that monthly payment would be worth $8,154 due to inflation.
How to Use Commercial Real Estate to Hedge Against Inflation
One way of using commercial real estate as an inflation hedge is by directly owning property, either all on your own or by investing in a private real estate equity fund. In both cases, recurring income and profits made at the time of sale are passed through on a pro rata basis to the investor. Investors seeking passive income generally invest as silent partners rather than attempting to actively manage a complex commercial real estate property on their own.
A REIT is a publicly-traded company that invests in income-producing real estate such as office and retail property, apartment buildings and hotels, and industrial and self-storage properties. REITs have a low correlation to overall volatility in the stock market, which can make a REIT a good alternative to directly owning real estate. However, owning shares of a REIT does not offer the same illiquidity benefits that direct ownership of real estate does, because REIT shares can easily be sold when investors emotionally react to transitory economic reports.
Value of Real Estate
The preservation and growth of asset value and the potential to increase recurring monthly cash flows by raising rents make real estate stand out from other hard asset investments.
Historically, real estate prices have outpaced the rate of annual inflation, as investors seek to preserve capital during periods of inflation.
In addition, rental real estate provides investors with a regular return on their investment in the form of the net cash flows generated from the rents that tenants pay.
Self Storage Real Estate is a Great Inflation Hedge
While stocks, bonds, and cash lose their purchasing power as inflation rises, investing in self-storage real estate may be the perfect inflation hedge.
Self-storage space is leased month-to-month, which allows owners to quickly adapt to changing market conditions. By contrast, residential leases are generally for one year, while leases on commercial property such as office, retail, and industrial are usually written for five years or more.
A growing number of investors are discovering that self-storage real estate is a great inflation hedge. This year, cap rates for self storage investments are expected to remain between 5% - 7%, generating returns that are about double the current rate of inflation.
There are a number of ways investors try to hedge against inflation, including TIPS, growth stocks, commodities and precious metals, cryptocurrencies, and real estate. Among these five options, income-producing real estate is the only hard asset that can offer investors the potential of increasing asset value over time and providing a recurring return on the capital invested through the net cash flow generated by tenant rent payments.