With US inflation hitting a 40-year high of 8.6%, the current economic conditions are ripe for a new wave of rising prices in every industry, from groceries to real estate.
In addition to the current inflationary trends, the rise in interest rates also impacts real estate values. As rates increase, so does the cost of borrowing money to purchase property.
It puts upward pressure on prices, as buyers are willing to pay more for a property that will appreciate in value faster than the rate at which their mortgage is accruing. While the currency’s purchasing power erodes, real estate remains a haven for those with the means to invest.
Investors are already anticipating these trends and are starting to pour money into the real estate market. This is evident in the rising prices of properties and the increasing number of transactions.
However, with the rising interest rate, it’s about time investors re-assess strategies and play the long game to leverage the current conditions through real estate’s innate nature to hedge against inflation.
The Impact of Inflation on Real Estate
Real estate has traditionally been known to be a hedge against inflation. As the cost of living increases, so does the value of real estate.
While this may be the case, in theory, there are a few things that investors need to take into account when considering real estate as an inflationary hedge. First and foremost, inflationary trends can significantly impact the real estate market, as they did in the 1970s.
To ensure that your investment will appreciate at the same rate or greater than inflation, you must be strategic about the location and type of property you purchase.
For example, properties located in areas with high job growth are likely to appreciate at a faster rate than the general inflationary trend. Likewise, investors must understand how inflation impacts the real estate market to make informed investment decisions.
High Correlation Between Inflation and Rents
Renters are understandably worried about how inflation will impact their monthly budget. Research shows that rents increase with the rate of inflation.
The landlords raise the rents to make up for their own increased costs of living and doing business. As a result, they can outpace rising inflation and increase their income.
Lower Vacancy Rates
Historical inflationary trends have shown that the demand for rental properties increases with the cost of living. As the dollar’s purchasing power decreases, people are less likely to buy homes in periods of high inflation.
Instead, they rent because it gives them more flexibility, and they don’t have to tie up all their savings in a property. Consequently, vacancy rates go down, and landlords can charge higher rents.
Dynamic Cash Flows
As opposed to traditional bonds that offer fixed cash flows, real estate income rises with time. Therefore, when investors re-assess strategies for this year, they should focus on assets with shorter lease durations, especially in development sectors with solid underlying fundamentals for growth.
An excellent example in this regard is hotels. Likewise, industrial and residential sectors also have shorter lease durations. But on the other hand, net lease properties have long-term leases.
How Does Rising Interest Rate Affect the Inflationary Real Estate Market?
Raising the target range by 75 basis points, the Federal Reserve has taken the most aggressive step in raising interest since 1994. While rising interest rates negatively affect many other financial assets, real estate tends to perform well in such an environment.
Multifamily and income-gene\rating real estate properties typically generate more net income in periods of high interest than bonds and securities. For one, real estate prices appreciate during periods of high inflation.
Moreover, the rising cost of machinery, material, and labor means there are few new development projects in the real estate industry. The property supply slumps translate to higher demand and prices for existing properties.
Secondly, inflation and rising interest rate margins lead to a spike in prices of everything, including rent. At the same time, the decrease in housing development means a higher demand for existing real estate, leading to spiking occupancy rates.
These conditions are suitable for landlords to raise rents, and they can do so without worrying about a decrease in demand. The effect is already seen in the market as CoreLogic data found that rents had increased around the country by 10.2% in Q3 of 2021.
Real Estate Investments That Thrive in High Inflation
It’s essential for investors to be aware of how their portfolios would be affected by inflation as the current interest rates and inflationary impact is breaking historical records. While real estate as a whole typically does well during inflation periods, some sub-sectors perform better than others.
You can either own an investment property or buy a residential REIT(Real Estate Investment Trust) that owns and operates residential rentals. For those looking for immediate income, residential rentals offer a way to receive payments that cover most or all of the mortgage payment, leaving some extra cash flow in your pocket each month.
In periods of high inflation, people tend to move less as it’s expensive and disruptive, so the vacancy rate for rentals decreases. Additionally, as prices increase, people tend to look for ways to save money, and one of the first places they’ll cut back is their housing budget, making them more likely to rent than buy a home.
All of this results in higher demand and higher prices for rental properties, which is good news for investors. When choosing the best residential property to invest in, it’s best to opt for multifamily housing.
The sector has an impressive historical record for standing out in any economic cycle. Yardi Matrix data showed a 13.7% year-over-year increase in apartment rental rates in 2021, with the average occupancy being 96%.
Multifamily renters also have a higher median income than those who rent single-family homes, making them less likely to be impacted by an economic downturn.
However, this doesn’t mean the single family rental market is out of the game altogether. CoStar Group’s research found the occupancy rate for single-family rentals to be 90% in the third quarter of 2021.
Likewise, built-to-rent properties are also gaining popularity, as they provide many of the same benefits as multifamily rentals but with the bonus of being brand new. Even with Covid-19 restrictions being lifted, many millennials are moving away from urban areas to work remotely.
Currently, 42,000 BTR housing units are under construction. Interestingly, experts forecast the number to double by 2024 due to the current pandemic-friendly trends and the benefits of living in a brand new home.
What to Consider When Investing in Multifamily Properties?
While investors can take out a loan to buy a multifamily property or refinance their apartment complex, they must keep track of the banks taking the tight lending approach toward large loans. At the same time, high interest rates can make it challenging to get a return on investment and make a profit.
Thus, investors should consider more than just interest rates when countering this situation.
- Local Market: Since real estate is a local business, investors must research the surrounding area’s demographics to ensure there’s a significant demand for rental units. For example, an area with a high concentration of millennials is likely to have a higher demand for rentals than an area with more retirees.
- Operating Expenses: Another cost to consider is the operating expenses, including property taxes, repairs, and maintenance. While some costs are fixed, such as property taxes, others, such as repairs, can fluctuate. It’s essential to have a realistic understanding of all the costs associated with owning and operating a multifamily property before investing in one.
- Financing Structure: Interest rate hikes typically impact short-term loans more than their long-term counterparts. Investors should also monitor the 10-year Treasury yield, as an increase in this number often leads to a rise in mortgage rates. It’s best to work with a qualified real estate finance & investment advisory firm to maximize investment returns.
Hotels or Hotel REITs
Compared to other commercial properties, hotels have the shortest ”leases” since they can practically change their room rates daily. Investing in a hotel or a Hotel REIT allows you to take advantage of rising prices due to inflationary pressures.
Business travel generally doesn’t slow down even during inflation. Thus, hotels that cater to business travelers are usually less affected by inflation than those that rely on leisure travelers.
Final Thoughts: What Does It Come Down To?
Recent reports from the real estate market are showing that even though the interest rates are rising, industrial investors and apartment buyers aren’t taking their feet off the gas.
While limited development and favorable fundamentals benefit real estate during inflationary periods, investors must not forget that a promising environment is not immune to operational or economic disruption.
Therefore, if you want to ensure a sizable rental income despite the rising interest rate and inflation, it’s essential to strike the right deal. Make sure to diversify your portfolio to include properties in different markets and economic conditions. Moreover, analyze the long-term prospects of each market and try to find the middle ground between high returns and low risks.
Black Collie Capital provides effortless access to real estate debt & equity financing and facilitates prudent investment decision-making.
Contact us today to start a conversation about your real estate project, and enjoy the certainty Black Collie Capital solutions provide.