Posted over 2 years ago

Buying Real Estate as a Hedge Against Inflation

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Source of US housing price graph: https://fred.stlouisfed.org/series/MSPUS

Written by: Max Vishnev, licensed NJ Realtor and real estate investor

 

There are many great reasons to own real estate: building equity, enjoying certain tax advantages that don’t exist for other asset classes, not having to pay rent, having a source of passive income (as with investment rental properties) – just to name a few. But another important benefit that often gets overlooked is that property ownership is also a great way to hedge inflation risk.

Purchasing a home today and locking in “cheap” long-term debt (in the form of a 30-year mortgage) has three major advantages, in terms of hedging the risk of rising inflation in the United States.

Three Benefits of Real Estate Ownership as an Inflation Hedge

First, the “real” (inflation-adjusted) cost of debt will decrease if inflation rises.

Second, real estate, as an asset class, is a natural hedge against inflation, since housing prices rise with inflation.

Third, if the property you buy generates rental income (say, a two-family home where you occupy one unit and rent out the other, or a pure investment property), the rents you charge should rise over time as well. So buying real estate with a rental component is an even better inflation hedge (and wealth builder) than simply buying a single-family home to live in.


Let’s back up for a second:

Mortgage rates and inflation were already low before the pandemic. But with the unprecedented crisis that has unfolded since March and the emergency actions taken by the Federal Reserve, we are experiencing a unique trifecta of very low inflation rates, historically low mortgage rates, and a Federal Funds rate of essentially 0%.

This, of course, comes at a time of tremendous fear, turmoil, and economic uncertainty, as we deal with a devastating pandemic the likes of which the world has not seen since the Spanish Influenza of 1918. In response to the economy essentially grinding to a halt and over 33 million Americans filing unemployment claims in the last 7 weeks, not only has the Federal Reserve dropped rates to zero, but the US government has passed rescue packages totaling to 3 trillion dollars, with more fiscal stimulus likely on the way.

Now, I will not pretend to have a crystal ball, and we know how reliably inaccurate most prognosticators are. So I’m not here to make predictions on where inflation will be in 1, 3, or 5 years. No-one knows, and you should ignore anyone that speaks with great certainty about the future. And, of course, most sensible folks are concerned about public health, jobs, and an economic recovery in the near term, not inflation risk.

What I would like to say, though, is this:

When a government, any government, prints a huge sum of money (and that’s exactly what the US government is doing), it increases the likelihood that inflation will eventually rise.

So this is a great time to think about hedging your longer-term inflation risk. And what better way to do that than by locking in a historically low mortgage rate on a 30-year loan and buying real estate?

Now, let’s introduce some actual numbers to make this point clearer.

A Look at Inflation:

The inflation rate at the end of 2019 in the United States was 2.3%, according to the US Bureau of Labor Statistics which was the largest annual increase since 2011 (when it reached 3%). Of course, this was pre-pandemic and before the government started printed huge sums of cash to try to keep the economy (and the American people) afloat.

Let’s assume that once the economy recovers and people start spending outside the home again (on things other than groceries) the inflation rate starts ticking upward. I’m not suggesting that’s going to happen next week, month, or even this year, but it is a feasible scenario for 2021 and beyond.

What would that mean for someone who can lock in a 30-yr mortgage at 3% or 3.25% today?

To answer that question, let us first provide a formal definition for inflation:

According to the Merriam-Webster Dictionary, inflation is defined as follows:

“A continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services.”

The Fed is currently printing a ton of money AND pumping a lot of liquidity into the financial system by resuming it’s program of “quantitative easing”, which includes the purchase of billions of dollars of Mortgage-Backed Securities (and other types of bonds) every day. This drives up the availability of credit for home borrowers.

Now, what has the inflation picture looked like historically in the US?

Average annual inflation in the US since 1913 has been 3.10%. That means, that prices on all the things we buy and consume have gone up by an average of just over 3% per year for more than a century. In simple terms, it means that something you buy for $1 today will cost $1.03 in a year, on average.

To put it another way, one dollar in your pocket today will not have the same buying power as one dollar in your pocket a year from now. That’s why average salaries tend to increase over time as well to keep up with rising prices on food, housing, toilet paper, consumer goods, and everything else we buy. Keep that in mind next time you look at a chart of average salaries 20, 30, or 50 years ago and wonder how anyone got by with those earnings. They did so because prices on everything they consumed were commensurately lower too.


Why Keeping Cash Under the Mattress is not a Good Idea:

We have just established that inflation “erodes” the value of the money in your pocket today. This is precisely why it’s generally not a good idea to keep your “rainy day fund” hidden under the mattress, no matter what your great-grandma, Prudence, recommends. With each passing year, that cash would lose value. The nominal amount would remain the same, of course, but the purchasing power of it would go down, thanks to inflation.

For example, if I were to put $10,000 under my mattress today and the inflation rate over the next 12 months turns out to be 2%, that same $10,000 will allow me to buy 2% less “stuff” a year from now. The “real” (inflation-adjusted) value of that cash I’m hoarding would be $9,804 ($10,000 divided by 1.02) this time next year. If another year were to pass, that $10,000 under the mattress would only have the purchasing power of $9,612. And if I were to leave the money there for 5 years, the “real” value would drop to $9,057 (10,000 divided by [1.02^5].

As you can see, hoarding cash is not a good idea in an inflationary environment (which is to say, a normal environment), since at just 2% average annual inflation, which has been the Fed’s target in recent years, I will have lost nearly $1,000 in purchasing power (or about 10% of the nominal amount).

By the way, at the historical average of 3.10% annual inflation, my $10,000 “rainy day” stash would have dropped in purchasing power to $8,626 (a nearly 14% drop in inflation-adjusted value).

Why do I bring up stashing cash under one’s mattress? 

Because in times of extreme volatility and uncertainty, it is a natural human instinct to want to hoard (whether it’s cash or canned beans and fish). And especially with the whipsawing people have taken in the stock market recently, it’s tempting to think you’re “safer” just keeping your money either in literal cash or the financial equivalent of cash (say, a savings or money market account).

Sometimes, that is in fact your best bet, but not beyond the near term.

Now for some good news:

While inflation might erode our cash stash under the mattress, it actually helps us when we carry fixed-rate debt. This includes fixed-rate student loans, car financing loans, and, of course, fixed-rate mortgages on homes. How does it help, you ask? Well, for a fixed-rate debt payment, the “real” cost of that payment will decline over time thanks to inflation.

Let’s use some numbers once again to clarify this important point.


How Inflation Benefits Holders of Long-term Debt:

Meet John, who has a FICO score of 770, a solid six-figure income, and a relatively small student loan balance (in proportion to his income, since lenders will review his debt-to-income ratio). John pays his credit card balances in full each month. He wants to take advantage of today’s real estate opportunities and buy his first home. John finds a great house with room for a nice home office, space for a home gym, and a large backyard for $625,000. He puts down 20% and takes out a mortgage for $500,000 (80% of $625,000).

If we take this example a step further and assume that he can lock in a 30-yr loan at a 3% interest rate today (which as of this writing is very possible for the most qualified borrowers buying a primary residence), his monthly principal and interest payment at that rate would be around $2,100.

Note on rates: to appreciate how low average 30-year mortgage rates are right now, it helps to see historical mortgage rates in graphical form (see chart below, sourced from the Federal Reserve of St. Louis).

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Now, what happens to that mortgage payment once you adjust it for inflation?

To find out, let’s further assume that the average inflation rate over the next 5 years will be 2.5% (a very reasonable assumption given the historical average of 3.10% and all the money being printed right now due to the pandemic and economic crisis). In 5 years, that monthly mortgage payment will still be $2,100, but thanks to the power of inflation, the “real” burden will be equivalent to $1,857 in today’s dollars. In other words, John will still be paying $2,100 to the mortgage company, but that amount won’t be “worth” as much as it is today. In fact, it will be worth $243 less per month in today’s dollars.

And if the inflation rate rises to 3% (in line with the long-term average), that would mean that John’s inflation-adjusted cost of borrowing would be ZERO percent, since the mortgage rate would be matched and negated by the inflation rate.

OK, let us now turn to the second benefit of buying real estate in an inflationary environment – price appreciation.


Real Estate Values Rise With Inflation:

The cost of housing goes up along with all other goods and services thanks to inflation. That’s why home prices have an upward trajectory over the long-term. The graph in the header image of this article (source) shows the median sale price of homes sold in the US between 1963 and the end of 2019 (not adjusted for inflation). 

In 1963, for example, the median price for a home was around $18,000. Wow – what a bargain! Well, not so fast. According to historical data from the US Census Bureau, the median income for all families in the US in 1963 was $6,200.

Of course, timing is important (just ask folks who bought in 2006 and 2007), and there are local factors that can dramatically impact home values in a particular neighborhood, city, or state. But, in general, home values tend to appreciate over time. 

Therefore, real estate, as an asset class, is a natural hedge against rising inflation, since inflation is the tide that lifts all boats, and the housing market is one of the boats – a very large boat, in fact (apologies for the confusing land and sea metaphors!).

Unlike the cash stash under the mattress discussed earlier in this article, real estate values will rise with inflation rather than be eroded by it (putting aside price volatility related to economic cycles). So securing long-term debt at historically low levels to purchase an asset class that tends to rise with inflation is “doubleplusgood”, to borrow the Orwellian “Newspeak” word. 

Your borrowing costs will decline in real (inflation-adjusted) terms, while the value of your investment (the home value) will go up over time.


Inflation Increases Your Rental Income:

Finally, let’s discuss the third way in which real estate ownership is a hedge against inflation risk. If you buy a home as an investment (a home that you rent out) or a multi-family home where you live in one unit and rent out the other(s), also known as a “house hack”, your rental income should go up over time as well. That’s because rents rise along with home values (thus the constant “rent vs. buy” debate).

For example, if your tenants are paying you $2,000 a month today for a rental unit and average rents go up, say, 3% a year, the rent you’d be charging on the same unit in 5 years would be $2,319.

In other words, if you purchase real estate as a rental property, you’ll enjoy the dual benefit of long-term price appreciation on the home and rising rental income, both of which will not only bolster your net worth but will serve as inflation hedges as well. And if you can take advantage of these dual long-term trends while locking in a historically low mortgage rate, it’s a win all around.


Conclusion:

Remember, you don’t need to buy a home purely as an investment property. You can get the best of both worlds – home ownership and rental income – by “house-hacking”. I’ve written about my own journey from long-time renter to house-hacker.

As a parting thought, despite the plethora of negative news headlines and scary economic and health stats, the current environment presents a unique opportunity to lock in historically low long-term debt to acquire real estate assets (whether a first home or investment property), especially if you expect inflation to rise from current levels over the next few years and potentially beyond. Purchasing real estate, especially income-producing properties offers a few key inflation hedges: property values and rents tend to rise with inflation, while the inflation-adjusted fixed-rate cost of debt erodes over time.



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