Real estate assets can maintain and even increase in value during inflationary times. Here are three reasons why real estate investing hedges against inflation.
Real assets, such as commodities, natural resources and real estate, possess unique qualities that serve as a hedge against inflation. Why? Because they hold intrinsic value. In other words, there is a scarcity of supply to meet the basic needs of investors.
Real estate is a good example of an asset that holds intrinsic value, as both the land the structure sits on and the structure itself meet a basic need but are limited in supply. As the likelihood of an inflationary environment increases due to the Federal Reserve’s monetary policies, it will be critical for investors to evaluate their portfolio holdings to understand how they may perform with inflation.
Over time, inflation-hedging investments, such as real estate, are expected to maintain and even increase in value. In this post, we will explore three characteristics of real estate investing that make the asset class a smart option during inflationary times.
What is Inflation?
In simple terms, inflation is the sustained increase in the general level of prices of goods and services. As time goes on and inflation increases, consumers’ buying power decreases with the same amount of money. Here’s an example: in 1990, what you could buy with $1,000 would now cost $1,980. That’s a 98% cumulative rate of inflation over 31 years.
There are two primary drivers of inflation: economic growth and monetary devaluation.
- Economic growth can lead to inflation in rapidly growing economies as companies begin to raise their prices for goods and services. As demand increases for these products, so does production, driving up production costs and impacting wages.
- Monetary devaluation occurs when a country prints excess money, lowering the currency’s purchasing power and making it less valuable. This typically occurs during a financial crisis as the central bank attempts to lower interest rates, making it easier to lend money.
So, how can investors safeguard their portfolios or even profit from inflation?
The answer is with real assets like real estate.
Appreciation
Real estate is unique because, unlike other real assets, it can generate income while hedging inflation.
One of the most beneficial aspects of real estate is appreciation. Historically, property values have appreciated between 3% and 5% annually, depending on the price index referenced. The U.S. House Price Index shows that prices have risen 3.4% per year, on average, since 1991. We will use this example in our illustration.
Illustration: If you bought a house for $200,000, assuming an annual appreciation rate of 3.4%, in ten years you’d have a property valued at $280,000. Comparing this same scenario to inflation from 2010 – 2020, there was roughly an 18.69% rate of inflation. Meaning, your $200,000 investment would be worth $237,381 ten years later. As you can see, not only did the property keep up with inflation, but it appreciated in value during the same time period.
Even during crises, real estate can appreciate in value as can be evidenced by the most recent crisis – the COVID-19 pandemic. The S&P CoreLogic Case-Shiller 20-City Home Price Index posted a 9.1% year-over-year gain in November 2020, up from 8.0% in the previous month. How can this be the case?
Strong demand for homes and other real estate assets coupled with constrained supply has allowed the housing market’s bullishness to continue throughout the year. Many experts predict sustained conditions for 2021 and possibly longer.
Cash Flow Advantage
Owners of real estate investments benefit from the cash flow generated from rent and other fees paid by tenants. Savvy investors with sound underwriting processes can identify assets that can be purchased below market value. Then, with a few improvements, property owners can attract tenants that will pay slightly higher rents for upgraded amenities and a prime location. The rental income generated will cover monthly expenses (mortgage payment, taxes, insurance, etc.) and produce additional monthly cash flow. If the asset is well maintained, it can also garner annual rent increases, allowing you to fight inflation, impacting taxes and maintenance costs.
Depreciating Debt
Real estate investing can come with big tax advantages, including depreciation rules that can dramatically reduce an investor’s taxable income. Those investing in rental properties are the real winners when it comes to deductions because, unlike homeowners, income-generating assets do not incur deduction limits. Money spent on repairs and renovations, management expenses and mortgage interest is tax deductible. These deductions enable investors to subtract rental property expenses from the cost basis on their annual tax returns, helping the property owner reclaim the costs of the income-producing rental property.
Here’s an example: Let’s say you purchase a property for $200,000 with the intention of holding it for ten years. The land is valued at $50,000, so the cost basis of the structure is $150,000. To attract quality tenants, you invest $100,000 in value-add projects, increasing the cost basis to $250,000.
Per the IRS, rental properties are assumed to lose value over time, allowing investors to take tax deductions according to the IRS Depreciation Table. To take advantage of the tax benefits, the asset must meet the following IRS requirements:
- The property must be owned by the person who is renting it to others.
- The asset must generate income (i.e., it is not held for personal use).
- Unlike land, the property must have a definable “useful life” that estimates the number of years before it will begin to lose value.
Conclusion
Inflation is inevitable. Investors can fight the effects of inflation by investing in real assets that perform well during inflationary periods. Real estate is an asset that can maintain its value during inflationary times and even increase in value due to appreciation, ongoing cash flow generation, and the ability to take advantage of specific tax laws.
Get in touch with a member of the Lucern Capital Partners team to learn more about our investment approach and how we have been using real estate for portfolio diversification for years.