Real Estate as a Hedge against Inflation

Real Estate as a Hedge against Inflation

January 28, 2021

In recent weeks there have been alarm bells ringing in the media about awakening inflation. To some, this alarm has been overblown. On January 13, the Labor Department reported that the CPI increased 0.4% in December, after gaining 0.2% in November. Year-on-year, the CPI rose 1.4% in 2020, while the “core” CPI number, which excludes food and energy, was up 1.6%. These numbers are actually pretty low. The average yearly core CPI for the last ten years has been about 2.0%. Numbers below 2% are usually perceived to be non-inflationary.

Also, with the appointment of Janet Yellen as Secretary of the Treasury, some say that we’re entering a period of harmony between the Fed and Treasury’s rate theory. In theory, this would allow the Fed to hold its stated rate target, holding inflation at below 2% through 2023.

So why the alarm? And if there is some substantial inflation on the horizon, do our real estate holdings work as a hedge against it? And if so, how?

In fact, at this writing (January 21, 2021), there is a wide variety of indicators which, taken together, should warn us that substantial inflation is probably near. Arguably, the two greatest drivers of inflation are: 1) the oversupply of money, and 2) economic growth. At this point, we have both in spades. Professor Jeremy Siegel wrote this week that the broad-based money supply known as “M2” (which is measurement of the US money supply, including money in circulation, checkable bank deposits, savings deposits less than $100k, and money market mutual funds) has seen a dramatic change in the COVID era. Since 1980, even during recessionary downturns, M2 has realized a consistent rate averaging 5.8% of growth annually. Between March and November of 2020, M2 grew by more than 25%. The year-long 2020 burst in M2 is the largest annual increase in this number in the entire 150 years for which we have data! He goes on to say that if this “expansion of reserves” continues to flow directly into the bank accounts of American businesses and individuals, it will be even “more powerful.”[1]

Several other indicators point in this direction. In January, Goldman Sachs raised its estimate for U.S. economic growth in 2021 to 6.6%. Also in January, Bloomberg’s survey of 84 economists yielded a median estimate of 4.1% U.S. growth per annum, a number that is clearly strong by recent standards. Also, Jeffrey Gundlach, renowned CEO of investment firm DoubleLine Capital, predicted last week that we would see a 2.5% CPI number as early as June.

Still, the Fed continues to keep short term rates extremely low. For this reason, many seem convinced that interest rates and inflation will stay low indefinitely, and they have positioned their portfolios accordingly. If a large number of these people abruptly move to adjust to a high inflation, high interest rate market view, there could conceivably be a seismic market whiplash. The upcoming stimulus and the consumer demand that will arise with widespread implementation of the vaccine could in turn cause supply side bottlenecks, and all of these things may further exacerbate inflation.

Hard Assets

Seasoned financial advisors often instruct their clients to move to “hard assets” (also known as “real assets”) when they foresee inflation like this coming. These expressions are used in part to express a contrast to the process by which the Federal Reserve generates fiat money and Treasury bonds—a process that appears soft and unreal to many. Hard assets include: metals, oil, scrap steel, machinery, agricultural products, and real estate.

Part of what makes these assets, such as real estate, attractive during inflationary times is that they almost always have some kind of “intrinsic value,” other than as a means of exchange. Most real assets have an industrial or practical value. And unlike fiat currencies, real assets have a track record of retaining much of their value despite any manipulation of the money supply that might come from the central banks.

How Does Real Estate Work as an Inflation Hedge?

When we say that we’d like to “hedge” our inflation risk, we mean that we’d like to hold an investment that appreciates in the face of inflation. This is one very important reason why at this point many investors are buying gold, oil, agricultural commodities, and of course, real estate. These investments tend to go up as the value of paper currencies and bonds goes down.

A good real estate inflation hedge will often work in three ways during inflationary times: 1) Real estate prices appreciate, 2) Income from rents grows with CPI, and 3) “depreciating debt” occurs, whereby the value of the real estate holder’s mortgage payments depreciates. For example, a $100,000 mortgage payment during the first year of a mortgage will remain the same nominally but may well only be worth $80,000 in the tenth year.

Perhaps an important thing to note here is that all four subsectors of commercial real estate seem to have tracked inflation better than the other three non-real estate hard assets. However, at the present time, on a national level, COVID may have damaged the retail and office sectors to the extent that it might be a long time before these sectors, reckoned as a national group, can keep up with inflation.

Right now, we are taking advantage of the current low-rate environment by selling strategic assets to harvest yield and by fine-tuning our longer-term debt structures. But, looking ahead to a more inflationary environment, we are also cautiously negotiating leases with a shorter lease term and CPI adjustments which will allow our portfolio to adjust as our country moves into a new economic season. Fortunately, we have assembled a strategic and diversified network of developer partners who continue to provide a large pipeline of qualified investment opportunities. This is well suited for the significant amount capital we plan to deploy in the coming months. 

[1] Jeremy Siegel, “Higher Inflation Is Coming and It Will Hit Bondholders.” Financial Times, January 18, 2021.

This article was written by Grant Humphreys, President of Humphreys Capital. 


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