The Pros & Cons of Investing in Income Property During an Inflationary Period

Investment property ownership has long been considered an ideal hedge for inflationary risk. In this post, we explore the pros and cons of investing in real estate today.

Richard Caldwell
The Pros & Cons of Investing in Income Property During an Inflationary Period
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Investment property ownership has long been considered an ideal hedge for inflationary risk. Whether commercial property such as light industrial, retail, or medical office, single family residential or multifamily buildings, purchasing income property with appropriate leverage can truly offer superior protection from inflation.

Why invest in income property during inflation?

First, property values have historically risen during inflationary times because investors believe tenant rents can be increased more quickly than during low inflation times. Second, property values generally rise with inflation due to increased tenant demand coupled with increasing scarcity of new development. Higher costs of construction typically create increased barriers to new development, and as a result, the value of existing property can be expected to rise as it is driven by a classic supply and demand scarcity dynamic. Finally, by carefully selecting financing with a fixed interest rate, investors will be able to use future (inflated) dollars to repay the loan, thereby effectively reducing the cost of borrowing.

What will happen this time for real estate investors?

Generally, we can expect the dynamic of rising rents and scarcity of new property development to drive up values during this cycle as it did in prior inflationary times. Whether a property is a local service-oriented retail investment or an apartment building, demand by consumers is at an all-time high in many categories for well-located and functional property.

However, we suggest caution. Growing demand will continue to be regionally and locally specific. During the COVID pandemic, we’ve seen a shift away from high density urban living to suburban and secondary or tertiary market lifestyle choices. This dramatic change has been seen in our largest cities, with several mid-size and smaller communities and states benefiting noticeably. Will this shift last in the long-term, or will our population and employers move back to cities and working from offices in more major metropolitan areas?

What is realistic?

Landlords can increase commercial property rents as much as they want, but it will do no good if they push tenants out of business or to leave their property. Commercial rent increases will need to be selective, focusing on properties with tenants that benefited from the pandemic and are likely to continue to thrive. Rising labor costs will challenge even the most stable businesses as there will be limits to how much they can increase the cost of goods and services passed through to their clients.

Impacts on residential rents and sale prices

Single family home prices and multifamily rents will also come under pressure from a similar dynamic. Since the earlier part of the Great Recession (2010–2012) in most markets residential rents and sale prices have continually risen. It is true that the crash of 2008 reset home prices and rents significantly lower, but that loss has now been more than recovered.

Today in most markets, home values and rents have risen to recover beyond a traditional rate of growth that would have occurred without the Great Recession. In other words, the ratio of home prices and multifamily rents to average incomes is tighter than in recent years. Home buyers and renters can only pay so much until they are forced to relocate.

New development will likely slow

What we can expect is generally continued limited growth in new property construction for commercial properties and slowing of development of single family and multi-family housing due to the significant increase in construction costs that became prevalent in the last 24 months along with higher borrowing costs.

The cost of borrowing for land development and construction will increase with rising market interest rates and pressure on builder profitability will likely increase and thereby slow new development. Banks and other lenders have been waiting a long time to increase interest rates charged for loans to improve their net interest margin (profitability) after an historically low-rate period of over 10 years. Now they will be able to increase loan rates, which can be expected to directly affect underwriting and leverage in loans thereby causing lower available leverage and further squeezing developer profits.

Bottom line: now is likely still a good time to invest

Our view of capital inflation and capital markets is that property values will likely continue to rise and rents will follow subject to market specific dynamics. Now is a very good time to acquire properties capable of providing durable cash flow, and to secure longer term fixed rate financing. The traditional hedge of real estate in this inflationary time should prove out.

What are the unique risks?

So, what are the unique risks of today? First and foremost, we don’t know what will happen as the pandemic subsides. To what extent will employers require team members to return to the office? Will professionals and consumers who left larger cities during COVID begin returning to larger urban centers for employment, services, cultural activities, and the sense of community that likely took them there in the first place?

Second, for single family and multifamily properties, with already historically high home prices and rents, affordability will ultimately limit how far rents can rise until tenant incomes rise to support higher rents.

And finally, at what point will real property asset values increase and non-real estate asset values decline to reach the inflection point where institutional investors that truly drive capital markets cause real estate to be less attractive to invest in? Yes, there is a great deal of capital looking for investments, but sophisticated investors will continue to conduct alternative asset investment analysis to obtain greater cash flow and appreciation. An example of this risk is, what will happen when bond yields rise sufficiently, and their values decline to make bonds a more attractive investment than they have been in decades? At some point real estate will find a value plateau and stop outpacing other asset classes.

Summary

We believe the traditional dynamics of evaluating and underwriting income property investments will continue to endure. Using real property with fixed interest debt at prudent levels can be expected to provide a useful hedge to inflation. However, smart investors will watch their local market to select excellent locations and should never stop their own alternative investment analysis for markets and asset types.

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