Before inflation surged in 2023, real estate sponsors often pointed to property investments, particularly multifamily, as an ‘effective’ hedge against inflation. But what does that really mean? A hedge, by definition, is an investment expected to perform well in the face of a specific risk. In the case of inflation, an ideal hedge is an investment that tends to outperform during inflationary periods.
For example, if you’re concerned about an economic downturn, you might invest in industries that tend to be more recession-resistant—such as pharmaceuticals, utilities, or defense companies. These industries typically have steady demand, even when the broader economy struggles, helping your investment outperform the market during downturns.
Similarly, many investors believe real estate—being a "hard asset"—serves as an effective inflation hedge. Hard assets like real estate, gold, and commodities are physical, tangible items with intrinsic value. They aren't easily diluted or devalued, unlike fiat currencies, which can lose value if central banks print excessive amounts of money.
Gold is often referred to as the classic inflation hedge due to several key factors. First, gold is a finite resource—its supply grows very slowly and can’t be artificially expanded like paper currency. Because of this scarcity, gold tends to retain its value over time, even when inflation erodes the purchasing power of money. As inflation rises and the cost of goods and services increases, investors often turn to gold to preserve their wealth. Its immunity to inflationary pressures often increases demand, driving up its price during inflationary periods.
Additionally, gold is not tied to any one currency or government, making it unaffected by monetary policy decisions, currency devaluation, or political instability. Unlike fiat money, which can be subject to the whims of central banks, gold's value is universally recognized and historically trusted. As inflation erodes currency values, investors often turn to gold to safeguard their purchasing power.
Real estate operates under a similar rationale. As a tangible, hard asset, real estate is expected to hold its value or even appreciate during inflationary periods. When inflation rises, property values and rental income typically increase, helping real estate investments generate higher returns. This occurs because real estate often has the ability to pass on inflationary costs to tenants in the form of higher rents. Moreover, property ownership isn't easily diluted, which means real estate can act as a store of value during periods of economic uncertainty.
However, while real estate is often lumped with gold as an inflation hedge, its performance is more complex. Unlike gold, which serves purely as a store of value, real estate comes with operational costs, debt, and market-specific factors. During inflation, operating expenses such as maintenance, labor, and property taxes also rise, eroding some benefits from higher rents. Additionally, rising interest rates, which often accompany inflation, can increase borrowing costs and reduce profitability for highly leveraged real estate investments.
So how did real estate, gold, and other inflation hedges perform during the most recent inflationary period? Here’s a quick analysis of the good and bad factors at play. One important point to highlight is that, over the long term (which is always key), real estate has shown the capacity to hedge against inflation. Here’s why:
Material Costs: The costs of constructing a building increase during inflation. Building materials—wood, pipes, electrical systems—all go up in price. This drives up the replacement cost of new buildings, which in theory increases the value of existing buildings. As the cost of constructing new competitive products rises, fewer projects are built, creating scarcity and increasing the intrinsic value of existing properties.
Rents are a Key Component of CPI: Shelter inflation is a significant part of the CPI (Consumer Price Index). When CPI goes up, rents tend to rise as well. This means that, in theory, property values increase as rents rise, offsetting the pain of inflation. Over time, you would expect rents to increase with inflation, which ultimately raises property values.
Rent Frequency: The ability to frequently adjust rents is critical in combating inflation. Hotels, for example, can reset their rates nightly, making them more inflation-resistant in theory. However, hotels are also highly exposed to rising labor and material costs. In contrast, industrial properties with long-term leases (e.g., 10-year leases with annual 2% rent escalations) may struggle to hedge against inflation if inflation exceeds these rent increases.
While real estate has long-term advantages as an inflation hedge, there were some significant challenges during the recent inflationary surge:
Labor Costs: The cost of operating properties, such as paying for maintenance staff, electricians, and plumbers, increased as part of the inflationary cycle, eating into profits.
Material Costs: Beyond labor, the cost of materials also rose sharply. Replacing appliances, installing new flooring, or performing other renovations became more expensive.
Debt Costs: Financing costs are a major factor in real estate value. As inflation rose, so did interest rates, making borrowing more expensive. This directly impacts real estate values, as higher financing costs can reduce profitability.
Cap Rates: Capitalization rates (cap rates) tend to rise during inflation due to increasing debt costs. Investors require higher entry cap rates to avoid negative leverage, making it harder to justify high purchase prices. However, this relationship is nuanced—expectations about future cap rate compression can also influence buyers’ willingness to accept lower cap rates in anticipation of future gains. This report from CBRE illustrates this point - for every 100 basis point movement in the 10-year treasury yield, multifamily cap rates moved about 75 basis points.
So, how can (multifamily) real estate continue to act as an effective inflation hedge in spite of these challenges?
Utilize Long-Term Debt: Avoiding short-term debt exposure is crucial. At Lombard Equities, we have been financing our recent deals with 5- to 7-year debt terms, accepting slightly higher interest rates now in exchange for more stability, which is essential for long-term planning.
Conservative Underwriting: We underwrite conservatively, often assuming higher expense growth than income growth. For example, we might model 2% year-over-year income increases while anticipating 3% expense increases. While this is difficult to gauge perfectly, it's a prudent approach that can protect against cost overruns.
Invest in Supply-Constrained Markets: Our firm focuses on supply-constrained markets, where scarcity drives rent growth and protects value. Although some investors prefer high-growth markets with new supply, we believe that investing in markets with limited new development is a more conservative approach.