It is no secret that inflation has reared its ugly head in the US and around the world. And it is easy to see its effects whenever you go to the gas station to fill up your car or to the grocery store to buy a loaf of bread. You can read the statistics: gas prices are above $4.00 while corn and wheat prices are touching record high in the futures markets. However, for the individual investor it can be difficult to gauge the devastating impact of inflation on his or her investment portfolio.
Most investors have the bulk of their money invested in paper assets such as stocks, bonds and mutual funds. Paper assets as opposed to hard assets like gold or real estate usually fair the worst during inflationary periods. The reason for this is because while goods and services are rising in price there is a simultaneous drop in the value of the US Dollar and the price of securities or common stocks.
Public companies tend to trim operations during inflationary and recessionary economies because they find it difficult to pass on higher production costs to consumers who are spending less. This usually means that stock prices decline along with corporate growth. This is especially dire for the individual investor’s stock portfolio because as the price of stocks decline so does the value of his or her portfolio. This situation is only exacerbated by the fact that while stock prices are dropping there is also a decline in the value of the US Dollar. The overall value of an investment portfolio is eroded by two factors, the falling currency value and the falling stock values.
Many savvy investors, during inflationary periods, chose to invest their capital in hard assets like commercial real estate to counteract and hedge against the forces of inflation. A commercial real estate investment such as the purchase of an apartment building offers distinct advantages over paper assets.
The apartment building investor is directly benefiting from inflation because as prices for goods and services rise, so do rents. The most popular method for the valuation of an apartment building investment involves calculating the building’s Net Operating Income. Rising rents and net operating incomes can increase the overall value of an apartment building investment. In addition to increasing the market value of the apartment building rising rents can also help to defer the increasing operating costs.
The US dollar can be viewed as any other commodity such as wheat or soybeans because its value is primarily driven by supply and demand. Banks and lending institutions have cut back their lending on most residential and some high risk commercial construction projects around the country. Therefore money supply for new apartment building construction projects is very difficult to obtain. Also, there are fewer commercial construction companies willing to risk the development of a new apartment building complex while the costs of raw materials are rising. What this means for the apartment building owner is that there will be fewer vacancies on the rental market and a tightening supply situation in many metropolitan markets. The tightening supply of new apartment units combined with an inflationary economy should continue to cause rent prices to rise.
The demand for rental housing in most metropolitan markets around the country is forecast to increase in the next five years. The new demand for rental housing is being driven by two major factors. The first factor effecting apartment unit demand is the rise of residential real estate foreclosure rates around the country. Many thousands of homeowners have been forced to vacate their homes due to an inability to pay their mortgages and subsequent bank foreclosure. In addition, many first time home buyers are finding it impossible to qualify for a mortgage to purchase a new home because banks have tightened their underwriting guidelines for new home loans. Home buyers with no or poor credit are finding it especially difficult to find loans because there is no demand in the secondary market for packages of sub prime mortgages. All of the above mentioned people are going to need a place to live and most likely they will be looking for an apartment. These new additions to the rental market should help to buoy demand for rental units all over the United States.
Simple economics dictate that as the supply of rental units remains steady and demand is increasing then the price or rents for those should increase as well. In my opinion many real estate analysts are underestimating the potential demand for rental units and therefore I believe that sale prices for apartment building should rise well above most people’s expectations.