3 Consequences to Expect in the Face of Rising Inflation

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.

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.

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.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.