There are many good reasons for investing in rental properties. Traditionally, cash flow is the goal that many real estate investors have in mind when they begin. However, the financial benefits of investing in rental homes go well beyond earning income from rent roll. One attractive reason to invest in real estate is to hedge against inflation.
What Inflation Means
Investopedia defines inflation as “The decline of purchasing power of a given currency over time.” What this means is that if you have $100 today, that money has a buying power you can define. You could select a list of items that you could obtain in trade for that amount of money. Perhaps a list of groceries, or a certain amount of gasoline or home heating oil, or a service from a local contractor like gutter cleaning. Due to inflation, those same goods or services will cost more in a year than they do now. The difference in price is the inflated cost of those goods. In reverse, this means that the value of that $100 has dropped.
What inflation means for workers is that their wage has less and less buying power as time goes on unless they receive a raise. Hence, wages increases based on the “cost of living increase” we in America have come to rely on ensure that our pay rate does not decline over time.
Inflation for those investing in rental properties also has implications. Imagine you have $20,000 to invest as a down payment in a real estate investment. If you buy an income property today, your investment will begin to grow as soon as you make it. However, if you wait, that $20,000 will not have the same buying power in one year. Hence, there is what is termed an “opportunity cost” to waiting to invest that money when inflation is factored in. Not only do you miss out on the gain in value of the investment, when you eventually do invest, but you also need more of your savings to get the same item you wished to invest in. Time and inflation are closely linked.
Why Inflation Is in the News Today
Before we get to why investing in rental properties, whether traditional or Airbnb, works as a hedge against inflation, we have to explain why this has become such an important conversation in 2021.
To understand why inflation has become a hot topic in 2021, we have to understand one of the main causes of inflation. In America, we use the U.S. dollar as our currency and also as a measurement of the value of items. The paper dollar has no intrinsic value. It is not backed by gold, silver, or anything of material value. The dollar is simply a promise by the government that a thing of value can be traded for this form of official money. Money in America is known as fiat money.
The government derives its power to print money through taxation and the promise of the value of the dollars it prints. When the government spends more money than it takes in the process, this is often referred to as “printing money.” In other words, the government hasn’t done anything to make the dollar worth more, but it is putting more into circulation. The inevitable result of this process is a decline in the value of the dollars. More of them, with no added value, means that the value declines.
Over the past two years, the U.S. government has pumped more money into circulation than ever before in the 245 years of our country’s existence. Both in terms of real dollars and as a percent of the total money in circulation. Since there is nothing of intrinsic value backing up these paper dollars, the value of them is lowered by such actions. Hence, inflation is the only possible result.
By pumping money into the economy, the U.S. government has diluted the value of the dollars you already had, and also the value of the wages you earn. More importantly for investors, the value of a physical item, like a home or a property, will have a higher dollar value, even though it has not changed in any meaningful way.
How Your Finances Can Be Harmed by Inflation
As a person investing in real estate in general and investing in rental properties in specific, inflation can harm you in multiple ways. First, the rent you collect from your rentals has a diminished value as time goes on. Thus, you need to be careful to continually raise the rent in order to derive the same buying power from the rental rate of the unit.
Second, property values go up. You may think of this as a good thing, and it does have a big benefit to you, as we will discuss below. However, one downside of an increase in the value of your property is that your property taxes, which are based on the assessed value, will rise. So you will pay more tax dollars on the same property. Nothing has changed other than the dollar having less buying power, so local governments will charge you more U.S. dollars in property taxes.
All of your other costs will also increase. Insurance, energy, maintenance, and realty fees will all increase simply because the value of the dollar has declined. So you need more dollars to pay for the same services over time.
Real Estate Inflation Hedge Strategy One – Equity
One way that you can combat this downward spiral is to own something that has an intrinsic value. Something that people need and will pay more for as the value of the dollar declines. Property is a perfect example of something with intrinsic value and that people have to have.
By owning rental properties, you lock in your “dollars” as property rather than have them sitting in a bank account losing real value as time passes. Since the assessed value of the property rises along with the decline in the buying power of the dollar, you protect your past earnings.
Property equity generally has an increase in value over time. Location, property type, the condition of a property, and the neighborhood’s attractiveness to occupants all factor into equity changes. However, over time, property appreciates roughly 3-5%, according to Zillow.
This 3-5% addition to your equity helps to balance out the annual decline in the value of the dollar due to inflation. With savings accounts offering fractions of a percent of interest today, money in the bank is losing value. Money in real estate is better positioned to hold its true value. The rise in value is a hedge against the decline in the value of the dollar.
Real Estate Inflation Hedge Strategy Two – Rent
In real estate investing for beginners, you need to know that rental property investment also has another hedge against inflation. Your rent roll can increase steadily. How often you can raise rent depends on three main factors. First, your legal contract with an existing tenant. Your lease agreement or other contract will define how often, and perhaps by how much, you can raise rent.
Second, government regulation can limit how often and by how much you can raise rent in some locations. Rent control is typically the name given to this federal, state, county, or city/town regulation of how much you can change what you charge for rent and when.
Third, the market price of your rental unit. How valuable your rental unit depends on its marketability. That value is defined by many factors such as its size, its location, and frankly how much someone is willing to pay you for it. Generally, rent goes up over time as long as there are no big market upheavals.
By increasing rent periodically, you can hedge against inflation when investing in rental properties. In fact, inflation is a reasonable reason to raise rent.
Real Estate Inflation Hedge Strategy Three – Debt as a Tool
The last major hedge against inflation is a long-term, fixed-rate mortgage. With mortgage rates at all-time lows right now, a low single-digit mortgage is easy to find for qualified borrowers. By locking into a low fixed rate, investors are able to ensure that the money they will be paying the bank back with will have reduced value over time. Thus, you are actually paying back less than that you borrow. Furthermore, mortgage interest on a rental property is deductible in real estate investing. Since many investors are going to use financing anyway, this hedge is one that many will enjoy, like it or not!
Real Estate Inflation Hedge – Wealthy Investors
Many of Mashvisor’s investor-subscribers are not wealthy. We are making a living through investing in rental properties. However, some hard-working investors do have extra capital to invest. With banks offering basically zero interest, and the stock market at all-time highs, property is a wise investment. Particularly for those with a long-time horizon. Meaning they can leave the money in the property for many years. Property is a way that investors can balance their portfolios. Rent-generating property has the added value of a positive cash flow.
Inflation is real. Automobiles, homes, energy, and many other necessities are costing you more today than last year. This trend is likely to continue, and the inflation curve is likely to become steeper over the coming years. Investment in rental property is one way some investors hedge against inflation in any economy. In today’s very unusual economy it just makes sense.
Note: The author is a real estate investor, but is not a financial expert. This story is intended to be informative, not a recommendation.