Real estate as an inflation hedge

Real estate as an inflation hedge

Real Estate Investor · Phoenix, AZ · Member since 2009 · 1k+ posts · 1k+ votes

I have read many posts here and elsewhere stating that real estate is a good hedge against inflation. A look at inflation adjusted SF home prices since 1890 does validate that view. (Sorry, don't know how to insert an image here to show the graph.)

My problem is that I am thinking of buying an apartment complex and am not sure whether it will be a good hedge against inflation. I understand that rents will hopefully go up with inflation. But what about the resale value? It seems to me that the resale value will only match the rent increase if we were to assume that interest rates will remain unchanged. But the reality is that interest rates track inflation. (That is, the "real" interest rate does not change much and it is the nominal rate that changes.)

Here is a set of hypothetical numbers to demonstrate my point.

Let's say the NOI is $100K today and the interest rate (cost of capital) is 10%. We can say the property is worth $1,000,000 ballpark.

Suppose prices rise by 50% over the next 10 years, thanks to money being printed, etc. If we were to assume that our rents and expenses would also go up correspondingly, then our NOI should be $150,000. That, of course, means that the rents are a good hedge against inflation because $150K in 10 years will be worth the same as $100K today.

But what happens if we try to sell the property at that point because we need the cash? If inflation is higher in 10 years by 5% compared to today, it means interest rates will also be higher by that much. Thus, a potential buyer will be capitalizing the $150K NOI at 15% instead of today's 10%, resulting in the resale value of the property remaining $1 million.

The problem, of course, is that $1 million then would be equal to $666K today, which would mean that we would have taken a 1/3 loss on our asset in spite of rents going up.

Am I right to worry about this when considering an investment in an apartment complex?

Vikram

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Developer · Garland, TX · Member since 2008 · 8k+ posts · 4k+ votes
17y

Vikram, I think part of the answer is to get financing with a fixed rate now. I am am fixed (assumable) on my office building so I see inflation as an ally.

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  • Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    15y
    Originally posted by Vikram C.:

    Am I right to worry about this when considering an investment in an apartment complex?

    Vikram

    Yes...I am having this same discussion with Phill Grove on his blog right now.

    You have to assume an indefinite hold time to use the real estate as a hedge. That is fine if you plan for it, but if you ever need to monetize that illiquid asset you're toast because the same pool of buyers can buy less property with loan rates chasing interest rates north.

    Part of the discussion we are currently having is whether or not lenders would call the loans on wraparound mortgages if rates ratchet way north too. That is an interesting one :mrgreen:

  • Real Estate Investor · Phoenix, AZ · Member since 2009 · 1k+ posts · 1k+ votes
    15y

    Hey Bryan. This must have been one of my first posts on BP that you have resurrected. Remember my other discussion about strategic flexibility? I am no longer interested in apartment complexes and therefore don't need to worry about the DCF not channging due to higher interest rates.

  • Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    15y

    Yeah...I know you aren't. I just thought others may benefit from the thread and additional discussion.

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