3 Consequences to Expect in the Face of Rising Inflation

by | BiggerPockets.com

With the recent changes in tax reform, many companies have increase wages and offered bonuses to employees. For the past half-decade, inflation was struggling to surpass 2 percent per year. Economists have offered contradicting opinions and at times seem puzzled. As the economy soared, wages have remained fairly stagnant. There are signals of change in that trend. Over 100 companies have either offered bonuses or raised compensation for employees. As the floor of pay structures increase, it would be logical to assume that wages rise on aggregate. As wages rise, inflation ticks up. The fed tapers inflation with adjusting interest rates. The relationship between interest rates and asset prices is an inverse one. As interest rates rise, prices move in the opposite direction. This is a lot to soak in.

3 Consequences to Expect in the Face of Rising Inflation

1. Rents should rise.

In a past article, I discussed that real estate is a hedge against inflation. Here we are. As inflation goes up, so too does the cost of living (rents). A thriving middle class is excellent news for the vast majority of landlords. As wages for workers increase, so too do the rents tenants are willing to pay for property. Consumption increases when the flow of money trickles into the hands of the working class. The 100 or so companies that are offering wage increases and bonus pay are contributing to new affordability of higher rents. As a buy and hold investor, this is a fascinating time to watch.

real-estate-market

Related: What You Should Know About the Roles of Inflation & Appreciation in Buy & Hold Income

2. Interest rates will rise.

Times have been phenomenal to borrow money. It’s been cheap to acquire loans and deploy capital. That feature of interest rates lends to allowing asset prices (i.e. housing) to reach inflated levels. As the cost of borrowing money goes up, asset prices go down. In the housing crisis of ’08, the Federal Reserve increased its balance sheet to loosen credit (and end a credit crisis) and add liquidity to the market by buying bonds which drove down interest rates. Buying bonds on the Fed’s balance sheet took the balance sheet to a historical level that now has to unwind. This will inevitably remove liquidity from the market and drive interest rates higher. This is uncharted territory and has never been done at these levels. Risk exposure here is unknown and will be delicate. Unknown risks make me cringe when money is on the line.

The recent boom of price appreciation we have experienced should slow or possibly reverse in the face of rising interest rates. This is contingent on the pace at which that happens. Multifamily properties could/should see headwinds on asset/property values. If the interest rates on loans move up 50 basis points, investors see a lower debt service coverage ratio (DSCR). That relationship is an important one when seeking financing. The pool of buyers shrinks as the margin of profit decreases. Sellers facing their balloon payment may be forced to refinance at lower price valuations. These are just some of the potential headwinds. They are not guaranteed, but certainly both conceivable and possible.

Related: How the Dire Future of the Retail Market Could Solve the Housing Affordability Crisis

3. Appreciation will slow or reverse as interest rates rise.

Prices have become tough to navigate. I recently listened to Sam Zell, a billionaire real estate investor, discuss the shrinking pool of buyers on properties. He anecdotally discussed that he couldn’t find opportunities to buy and was currently selling off some real estate assets (this should be a signal to investors). The properties he was selling a year ago had a pool of 15 buyers who were bidding up prices on properties. Currently there are few buyers with shrinking chances to close. He insinuated that the parabolic move of real estate prices over the recent period may have begun to reverse trend. It is never wise to base decisions off of a single anecdotal piece of information, but it is wise to listen to experience and wisdom. Mr. Zell possesses both.

market-index

The last six months have seen a 50 basis point uptick on the 10 year treasury. Financing loosely follows that movement. It tends to be used as a barometer for the cost of borrowing. Multifamily sellers will be forced to react to borrowers having to acquire loans at slightly higher rates. Cap rates may begin to climb as sellers become more motivated and forced into price reductions.

The markets are a fascinating monster to watch and be a part of. Studying market cycles and history of market crash periods can help any investor grasp risk exposure. Most great investors have a deep understanding of exposure to risk and reward. What separates the good investors from the great ones is how they position themselves in the relationship of risk and reward. As a student of macro economics, I am trying to grasp the present situation by studying its history.

What are you currently seeing in your local market—and what trends do you predict will take hold in the coming years?

Let’s discuss below.

About Author

Gus Ross

Gus Ross is a managing member of Ownup Capital. An accredited investor with goals of expansion, Gus is always evolving strategies for acquisition and analysis of properties throughout the country. An avid reader and seeking to learn and grow everyday, he has ultimate goals of philanthropy, business, and personal growth. A visitor at local REIA meetings, he is always seeking to network and meet investors and align goals and interests.

Ownup Capital

23 Comments

    • Gus Ross

      The idea of that scenario means fixed income products would see insane inflows. Having read your piece on Antifragility, I share a similar strategy with Nassim Taleb and love his work. Any spike in interest rates will reward those holding on to cash and little debt.

      Thanks for the comment Andrew!

    • Rob Cook

      Andrew, I did it in the late 70’s and made money. Easy money actually. Just had to embrace seller financing, Land contracts, contracts for deeds, agreement of sale modality. I got my real estate sale license in 1978. In Hawaii! Oh boy! Like jumping out of a car running at 70 MPH. A good learning experience!

      Bottom line is, when there is high inflation (and the usual accompanying high-interest rates), creative deal-making can harness the positives and mitigate the negatives, for a net gain. Not fun, per se, but doable. One has to deal with the market as it is, after all.

      We flipped house in Honolulu for amazing gains despite the 21% mortgage rates. Lots of offsetting metrics to consider. So whatever tomorrow brings, we can make money, regardless. Just have to be flexible and aggressive, as always.

  1. Rob Cook

    Gus. I like the way you think. There are so many interdependent metrics that is is almost impossible to sort out and make a reliable prediction. Housing demand has to be kept on the radar, both homeowners, and renters. It is easy to go down a rabbit hole following one theory or another and be blindsided by some other metric which overrides the “usual” indicators. It is a risky time for us. It is unprecedented, to my knowledge, having such low-interest rates and “announced inflation.” This is not only a disconnect but a fallacy in my opinion. Who does not think there is high inflation and has been continuously for the last 15 years? Only the Liars in Washington, D.C. are of the stated opinion that inflation is low. BS! What has NOT increased regularly and continuously in price?

    SO, the warning is that listening to the liars, will not serve one well. I think the key is to make an independent, objective observation of the FACTS and reality, and then decide what is real and what is BS.

    To that, I say, the bubble has been reinflated and is overdue to burst again. Apparently, nobody learned anything from 2008. My answer, and approach, is to treat Real Estate Investing, as a business, not really an investment. I know this slaps the folks who dream of a “passive income” flow from real estate ownership, right in the face. But, it is what it is. Counting on, PLANNING on appreciation, is a losing game, with real estate or stocks. And in this economic environment, being arrogant enough to even TRY to predict the future, let alone act on it thru investing, is literally, gambling.

    The basics will prevail. Supply and demand. Housing will always be needed. The higher interest rates go, the higher inflation will too. In my experience over the last 40 years as an RE investor, inflation wins – meaning the price increases overpower the down pressure of interest rate increases. We will see if this re-occurs this time around!

    • Gus Ross

      Thank you very much Rob. Your post is very thorough and I highlight in your first passage where you wrote “It is a risky time for us.” Though there doesn’t seem to be a systemic risk like there was in banking in 2007-2008, the idea of quantitative tightening appears to have significant implied risks.

      And to note even though I don’t notice a systemic risk like there was in the Great Recession, the entire point of a black swan is that we don’t see it coming.

      Thank you very much for your contribution to the article.

  2. Jerry W.

    Gus,
    I am very impressed by this article. You provide a lot of good data and historical perspective but are quick to point out that there are simply somethings we will not know for certain. I remember getting a loan to buy my trailer house and was relieved to get it at 14% instead of 17%. Luckily the land was only at 10%, yet I cringed last month when I had a 5 year ARM mortgage go up from 4% to 5.25% on a $180K loan. That was about over a $150 per month rise in my payment. If you have a million out there in loans you can figure on about a $850 per month rise in your monthly payment if you only go up 1% on interest. I truly kept expecting huge inflation to hit as soon as the Obama administration began pumping large amounts of money into the economy. Our national debt soared, but we of course just kept printing money and spending it, while keeping interest rates artificially low. While that can help push the economy sooner or later I figured we had to have runaway inflation. I am still amazed it has been so low for so long.

    • Gus Ross

      Thanks Jerry! To even conceive of a loan at 14% makes me want to get into lending. The Fed seemed to share your surprise with low inflation figures and it would be speculation to peg causality. I have heard a couple of arguments that had some merit though one will never know. One related to the advancement of technology lowering overall costs of delivering consumer products (i.e. amazon eliminating the need for brick and mortar), and the other contributing it to global central bank stimulus being injected simultaneously. On a final note, HARP ends soon just in case you’re looking to refinance out of that ARM and get into a fixed rate loan at a better rate.

    • Brent M.

      We’ve already seen massive monetary inflation with the conditions that you’ve described. Defined as an increase in the money supply. What’s been delayed to some degree is price inflation, though buyers of housing, health and tuition might argue it is already here. We’re balancing on a razor right now, low rates destroying pensions and savers, higher rates will pop the bond bubble and be worse than 2008. Cash flowing real estate, without too much leverage or adjustable rate loans, is about the only thing I like right now.

  3. John Barnette

    Superb article. A lot to think about. I am also a fan of the thinking of Harry Dent who is a semi famous finance/real estate writer/analyst/salesman. Has some similarities and some also very well argued opinions that offer other futures. I have a portfolio of 11 properties in the Bay Area and am self employeed as a residential Realtor. Lots of eggs in one basket, nearly 800 credit score, “fair amount” of real estate debt and very little other debt. Excellent cash flow believe it or not on the RE. Would be interested in talking one on one. See what your organization does in more depth. Considering branching out and diversifying more and turnkey is not gonna work me, and limited experience with apartment buildings.. let alone out of state. Also very strongly prefer 1031 potential. And have keen insight into the Bay Area real estate market….which IMHO is paramount. Would love to chat. Cheers

  4. Connelly Hayward

    A good thought-provoking article. One bright light could be for those who have debt at a fixed rate on rental property in an inflationary period. Their debt service would remain constant while rents would increase due to Inflation. Under this scenario cash flow would increase. Of course, this is strictly a buy-and-hold scenario, and where refinance won’t be required in the future. That is, no balloon notes after the rates go up. The opportunity here might be to acquire properties in areas where rent demand will remain stable. The trick that is trying to figure out which areas will have a steady demand for rent. There is also the thought that as interest rates go up there are fewer home homebuyers thus increasing demand to rent a home.
    As it has been said, many unknowns in this market. We are in an unprecedented place, which makes things interesting. But, there will be opportunity for those who know how to look for it.

  5. Alexandria Perez

    I don’t believe companies are boosting wages with the new tax reform. While Walmart and Starbucks are boosting wages (yay) most companies are giving employees a one-time $1000-$2000 bonus. That will not cause inflation in the way that you are describing.

  6. Josh Collins

    Great article Gus. With the stock market at all-time highs and real estate prices seemly pretty high themselves, I think we need to think about these things sooner rather than later. If you had $2M in real estate with good cashflow, 75% LTV on 5 yr balloons and $200K on the sidelines would you be looking for more real estate deals or would you be holding to keep some powder dry? Or just keep the money on the sidelines in case interest rates correct to 7.5% (totally arbitrary), for example, in 5 yrs?

    It’s an interesting time to have some free capital. I am of the belief that the best time to invest is 5 years ago and in 5 years we’ll be saying the same thing. However, I want to consider protecting assets at this interesting time also.

    • Gus Ross

      Thanks Josh and I love your question so I’ll do my best to give you a thoughtful answer but preface that answer with this … I am not a licensed financial adviser and this isn’t advice intended to for you to make financial decisions based off of. It is strictly my opinions and views.

      Now that that’s out of the way…

      I agree with your second statement wholeheartedly. That being said, the allocation of the 2 million in real estate would really need a better understanding of the positioning. In my view, right now a very relevant question relates to the Return on Equity (ROE) of the real estate assets. Single family homes purchased anywhere from 2011-2015 in coastal areas had significant appreciation and probably skewed the the pendulum of ROE. Thought the cash flow of those properties are positive, it is possible that it could be deployed more effectively.

      5 year balloons do have me concerned and seem a bit risky in the current environment. I would explore options to refinance and extend the balloon period. The cash on the sidelines you referenced is actually mentioned in my article previous the current one. I stated I’m still a buyer but stick to underwriting disciplines that got me here. In essence, you can still be a buyer but have nothing to buy. I am a risk averse investor and would rather not do a deal than do a bad deal. But I am always looking for an opportunity and submitted an offer this week on 65 units. With the 200k I would be defensive in underwriting but still actively looking for opportunity.

      Best of luck in all of your future purchases either way and thanks for the comment!

      • Josh Collins

        Great reply. Thanks. I’m actually in the large storage space niche (think mini-storage on steroids for small businesses). So I’m not dependent on the Single Family Rental or apartment type of real estate. Although, like SFR and Apartments returns are getting squeezed and interest rates are likely to go up. This also helps explain why I asked the question. I have 20 yr commercial loans that are very difficult to get terms longer than 5 yrs on. I’ve currently decided to continue to develop properties to build these facilities because I can create a bunch of sweat equity and better returns without having to come to the table with mucho capital.

        However, with that said, I was trying to be pretty vague in my question as I think the interest rate issue is something that I wonder if I should save for a rainy day or if I should continue going full-bore. Obviously the answer is somewhere in the middle but I appreciate your opinion on this as a build my case for my properties.

        BTW, I did read the other article (sorry, I didn’t realize that you wrote that one too). Again, I’m using all of these thoughts/opinions to make my decision.

  7. Eric Bilderback

    This topic is both important and interesting. Personally I am hoping for inflation. I personally have quite a bit of debt and inflation will shrink the value of that debt. If rents go up by 5% and the value of my debt decreases 5% that is a win. I also think the Fed and other governments will be extremely cautious in raising interest rates because everything is so leveraged. Goverments are trying purposely to inflate the economy. And while there maybe some very modest rate raises the Fed will be doing it on eggshells. Its like football, if your losing you need to be aggressive. It is okay to throw against pass coverage when you need to make something happen. Like wise it is painful to watch your time try and hold on to a lead at the end playing soft which many times leads the other team to claw themselves right back in the game. Until the game is over and I am financially free I plan on being aggressive.

  8. John Murray

    I have always been fascinated by the financial history of the United States. The Lawmakers and the Courts manage risk by enacting and enforcing financial policy. The US has been at war for the majority of of our history. Only about 18 years has the US been at peace since our inception. About 222 years the United States has been at war. The cycle of expending ordinance and restocking ordinance has a major role in the cycles of our economy. Now comes the wisdom part. At the end of each ordinance expenditure cycle inflation has to happen to inflate and currency has to adjusted. Some of my greatest days I spent digging in and putting a fresh mag in my weapon. Ain’t that America you and me. I plan on adding a million to my net worth in the next cycle. No Fear on Earth!

  9. David Sussman

    Very interesting article! It’s sounding more and more like a done deal that interest rates are going to be raised next month, according to the news. As someone who is hoping to start investing in SFH buy & holds in the next month or two, this is obviously a very interesting topic for me! I’d love to see some follow-up articles from you on the subject.

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