After ten years of steady economic growth and low interest rates, inflation is now beginning to rise in the U.S. Inflation is expected to continue to rise, and it’s vital for real estate investors to understand its effects and how to mitigate it.
What Causes Inflation, and How Does It Impact Real Estate Returns?
Inflation is often the result of two economic theories: demand-pull inflation and cost-push inflation.
This occurs when the demand for goods expands faster than the supply. With lower interest rates, everyone has more reason to borrow and an increase in demand. This then drives prices higher, including property values and rents.
This type of inflation is defined as an increase in the price of inputs required to make a good or perform a service. The potential for this phenomenon is always lurking around. However, with trade wars looming and tariffs imposed, these catalysts could accelerate cost-push inflation.
Cost-push inflation is the worst form of inflation. It is harder to control and leads to slower economic growth. If your investments lean toward renovations and the need for materials like steel and wood, you will probably be subject to higher prices, which can minimize your returns.
However, on the other hand, these inflated prices make it harder for new construction to get going or be finalized, so that causes more competition in the market if you are selling or renting.
Mitigating Inflation Risk
Inflation definitely impacts real estate investors, but there are ways to control this risk. Let’s look a three ways to mitigate it.
Inflated operational and maintenance costs can be offset in the way a lease is structured. Use lease terms like expense stops and escalating rents. With an expense stop, the tenant pays expenses exceeding a price ceiling set in the first year of the lease. These expenses can include things such as utilities, property taxes, insurance, and maintenance of the property.
Escalating rents are the possible future increases in rent set at the beginning of a lease. With this type of clause, you’ll want to employ a short-term lease, which offers owners the ability to reset rents annually, based on market trends, new renovations, or rising inflation.
Location is everything. When you own property in a strong market, you will be more likely to gain inflation-offsetting returns over those with property that is less diverse with weaker demand. In these markets, there is likely to be less demand and less opportunity for rental growth. In turn, what you want to have is property in a resilient market with barriers to other investors entering, diversity, and proven growth. Then you’ll have much more demand than supply giving you the edge to sell or rent at a high return, regardless of inflation.
Capital Stack Diversification
With a capital stack, you have debt and equity. Diversification across both parts of the stack will enable smoother returns during times of inflation, as debt and equity investments perform differently depending on the economic conditions.
In inflation, debt investments with fixed interest payments usually underperform. With low or falling inflation, the opposite typically occurs.
Investments on the equity side of the capital stack, however, act as a hedge against inflation. These perform better under replacement cost and lease structuring. Debt and equity in your portfolio will help reduce the impact of inflation, balancing out risk.
Should You Buy and Hold or Fix and Flip in Inflation?
It depends on several factors. If you want to ensure that inflation doesn’t cut into your profits, you’ll need to look at several aspects, as discussed, including the market and its strength based on the location of your property. Inflation can be a good thing for rental properties, depending on the demand in that market. Fixing and flipping could be better, but this would be influenced by the cost of materials and the health of that market.
The best thing you can do is to keep a close eye on how inflation is impacting all the different elements associated with real estate investing. Then you can make an educated decision on what to do with your portfolio.