Who cares about inflation? It depends on when you ask. In the US, since the 1980s we have been dealing with a relatively lower level of inflation of 2% – 3% on average and even lower during the last decade (2010-2020). During this time, most people did not really care about inflation. All of a sudden, at the time of writing this article in May 2022, inflation is raging at an average of 6% – 7%. Now, it’s what everyone cares about. As we talk about ways to invest your money to beat inflation, it is important we explore real estate as an asset class to invest in, I would like to explore real estate as an asset class.
First, lets put the inflation numbers in the US in perspective with some data. If you look at the chart below from the US Bureau of Labor Statistics, you can see the history of inflation since 1958 in the US. People who were adults in the late 70s and early 80s are the ones who truly have experienced inflation – an entire generation after that has not really seen that much inflation – that all started changing during the 2nd half of 2021.
US Price Inflation history 1980-2022 (Mar 2022)
So now, the question on everyone’s minds are how do I invest my money to beat or keep up with inflation. Bonds and CDs, savings accounts etc are definitely not going to help you do that. In general, investing in equities (stocks) for the long run always has helped beat inflation. Now, people are getting into Government Series I Bonds (Inflation bonds) but there is a limit to how much you can invest. So as you start wondering what other asset classes exist to help beat inflation, one asset class to consider is Real Estate. As I have explained in an earlier article , there are many ways, active and passive, to invest in real estate. Not all of them are created equal and certainly not all of them are for everyone. I have personally chosen to invest in long term buy and hold residential real estate. Lets first examine a few questions.
How does Real Estate earn money?
Since my experience is with long term buy and hold residential real estate (Note: I don’t mean buying your personal residence here but buying a property for investment purposes), I will stick to talking about that here. There are 2 ways real estate makes you money:
- Cash flow through rents – if you did your analysis right and picked the right property, you will make a profit after paying off all your expenses. I talk about this in detail in my article on ‘Am I making a good return on my properties’. Depending on the class of neighborhood, you can earn a return between 5% – 10% on average. As of the time of writing this article, with real estate values so inflated, its pretty difficult to make those kind of returns if you buy today but deals can be found – you just have to look hard. You might end up with 3% – 5% returns instead. However, this will increase over time. This is something I will explain in the next section. There in lies the real truth behind why real estate becomes a good hedge against inflation.
- Property appreciation – I never like to bank on appreciation but it is a reality that you will see appreciation in property values. Don’t bank on the kind of property appreciation in the last 2 years (2020 – 2022) of around 19% – 20% because that is pretty unprecedented and unsustainable, but in general it’s reasonable to see a 3% – 4% increase in values annually just barely at or above inflation. As you continue to build equity in the property, you enjoy more of this appreciation over time. The below chart can show you the median housing price trends in the US.
So between the above 3 ways, you are earning a pretty robust rate of return on your money
IMPORTANT SIDE NOTE: Real estate returns are very local. Above charts and data are national so use them only as guidance. Your local market could be different.
So why is Real Estate considered a good hedge against Inflation?
As I noted above, the cash flow from real estate tends to grow over time. How is that? Its because of 3 reasons:
- Rents will grow typically with or above inflation – A good landlord will always ensure rents keep up with inflation. So you can expect to always raise rents (unless you are already priced well above the market) every year or every time you renew your lease.
- Your biggest cost (Mortgage) is fixed over a period of time – One of the best financial innovations in US history has been the 30 year mortgage. A lot of smaller investors like myself buy properties using a 30 year mortgage. Independent of inflation, the mortgage amount (Principal + Interest) is fixed for the 30 years or whatever duration you buy it for. Of course, a lot of investors finance their properties in other ways too.
- Tax advantages allow you to re-invest the savings/profits – there is an opportunity cost for you to use the savings you make by the minimized tax $ and invest it further.
When you combine the effects of the above 3, your profit margin grows over time. I did not truly appreciate this when I first started buying the properties. But especially with the first 2, even in a period of 3 years I started seeing the returns start to expand. Imagine what this will be over 10-20 years. The effects of compounding are even bigger.
So is real estate still a good investment in this hot market? Can I still beat inflation if I buy real estate now?
The short answer is yes but you need to work harder to find the right deal. I had been talking to a friend of mine about real estate for a while now and he finally decided he was ready to take the plunge. But his question was whether 2022 was the worst time to start his real estate journey given how inflated prices are now. My advice to him was to always follow the numbers. And after months of searching, he finally took the plunge and recently bought a property. His rate of return is not looking that great now but I told him this is going to get better over time. Plus, we should not expect to hit home runs in the first deal. That said, I am very convinced over time, this will start looking much better.
But isnt a real estate crash coming on the horizon?
There are people who tend to compare the inflated home prices of today to the time preceding the great crash of 2008. Unfortunately they have not taken the time to understand the fact that the conditions between 2022 and 2008 are very different. I am not a forecaster but i can tell you one thing – even the long term buy and hold investor who bought in the peak in 2006/2007 eventually came out whole and made good returns if they waited patiently until now. So my message to you is – dont try and time the market. Invest in it as long as the investment makes sense.
Concluding comments
I don’t for a moment suggest real estate is for everyone because it is not. But for those with the interest and desire to diversify, real estate can have some significant advantages that I described in this article. Like I always say, determine if real estate has a place in your asset allocation and if it does, what the proportion it should have. I dont want people to get into real estate by seeing the ridiculous rates of return lately because thats when social media channels and popular media goes abuzz with it. Invest using conservative assumptions and you will be fine.
Thank you for reading and I wish you luck in your financial journey.
Disclaimer: I am not a financial advisor and all the information in my articles are from my personal experience and are for informational and educational purposes only. Please consult with a financial advisor or CPA for professional advice.
