Factor in Inflation when performing rental analysis?

Question

I was curious if any of you factor in inflation of the property values when you are analyzing rental properties return/future value?

Over time, real estate generally appreciates and has been a hedge against inflation.  Do you account for this in you analysis for future value down the road?  Or do you consider appreciation of property values an extra perk to owning property?  What % of inflation do you assume if you use it in your analysis?

For example if you had a 30 year mortgage on a $100k SFH, and you had 2% inflation a year the Future Value of the home would be around $181K in 30 years.

If you didn't take into account inflation you would have only assumed $100k in equity upon paying off the loan instead of $181k.  This is an $81k discrepancy in value.

Account Closed · Answer

I expect appreciation over time in my market.  I do not purchase a property based on appreciation though.

Location is going to play a big part in any appreciation there will be.

Jon Holdman · Answer

You mean appreciation in property values, not "inflation" per se.  That's an ever bigger no way for me. That's even less predictable than inflation.  With inflation, there's an organization that at least trys to control it.  Whether they really can or not is a separate question.  House prices do whatever they want to do.  I've been making the assumption they won't go down, but that's proving to be optimistic.

J Scott · Answer

Like Jon, I won't use it to determine whether a deal is good or not, but I do use it to model my IRR...

I assume 2% for increase in rents and 2% for inflation of expenses...

Jon Holdman · Answer

No way.  You can, sure.  And it makes rentals look great.  Rent goes up 3% a year.  Expense go up 3% a year.  P&I stays the same.  Your rental looks better and better.

But its nothing more than a guess.

I just looked at the apartment building I first rented in 30 years ago in SW Houston. I paid $325 a month for a 1/1 with a den.  It says its been remodeled recently.  A 1BR rents for $400.  So maybe $450 or $500 for with the den.   Inflation would tell you it would rent for $741 now.

Now, perhaps this area's gone done hill.  And perhaps a comparable 1/1 with den really does rent for $750 now.  But we're not talking about a comparable property, we're talking about the SAME property, which is what you're talking about when you project into the future.

Just as easily could go the other way.  A building in the "LoDo" area of Denver 20 years ago would have truly been in the hood.  Today that area's hot and trendy.

So, don't use inflation to slap some lipstick on a crummy deal.

Paul B. · Answer

This is going to be very subjective.

For me, I always have it in the back of my mind that there should be some appreciation over time, but I consider it a bonus and nothing more.

Moreover, if you assume that real estate will, at best, keep up with inflation over the long haul (and there's no reason that it should out-pace inflation, is there?), then whatever appreciation you have will simply be eaten up by inflation.

To use your example, if inflation is 2% over 30 years, yes, the house would be worth 80% more, but the price of bread, milk, and toilet paper would have also gone up 80%, so you're not really ahead of the game at all.

My business model is that the property has to make sense here and now, today. It has to be completely self-sufficient and earn a respectable current cash ROI and current cash ROE.

I am not willing to own alligators to fund speculation on appreciation.

Brendan J. · Answer

David,

To piggy back off Jon, when you talk about the rise in home values over a period of time as it relates to equity, its called appreciation. The rise in costs over a period of time for comparable items (gallon of milk, eggs, bread, gas, etc) is called inflation. They are two separate animals and most investors here will probably assume that appreciation keeps up with inflation over a long period of time. A fair estimate would be 3% per year.

So in your example, 181k might seem much better than 100k, but if you can only buy the same number of eggs, milk, bread, and gas as before, have you actually increased your buying power at all? Probably not.

Bryan Hancock · Answer

If you are not inflating the rents then inflation matters little IMO.  The dollars will be worth less so it is just a mental exercise to think in future dollars instead of present dollars.

David Robertson · Answer

I was actually talking about inflation of property values which effects the overall equity accrued in a property, instead of actual rental income inflation.

Good advice though.  Inflation is speculative and it should probably only be considered as an extra bonus.

Bryan Hancock · Answer

I use 3%.

Make sure you have escalators for your expenses as well as your rents.  The only thing that will be static (hopefully) in your analysis is your P&I payments since the fixed-rate debt payment does not change.

Factor in Inflation when performing rental analysis?

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