With inflation becoming a reality for the first time in decades, it is prudent to understand what inflation is, what drives it, why commercial real estate is a sound hedge against it, and how to access that hedge.
Inflation can be simply defined as an increase in the cost of goods relative to the quantity of money in the economy. In my Freshman year at Stetson University, my Economics Professor Dr. Neal Long explained it this way. Inflation is either “Cost push or demand pull”. Cost push inflation means that the cost of creating goods increases, causing inflation. For example, if hourly wages or necessary steel used to produce a product increase, that cost will typically be passed along to consumers in the form of higher prices for the produced good. In a nutshell, end buyers of the goods produced will get less for their money. Demand pull inflation occurs when the quantity of a product demanded by consumers increases but there is not a proportional increase in supply. For example, the classic Dutch tulip bubble was caused by a dramatic increase in the demand for tulip bulbs but there was not a similar increase in the supply of tulip bulbs. Again, consumers get less for their money.
The cause of the current inflationary environment in the US can be debated but whether it is the result of a flood of money chasing the same goods (long term) or a decline in the availability of goods due to short term interruptions in getting goods to consumers (transitory), the reality is that inflation is higher today than it has been in decades. According to The Guardian, the US inflation rate reached 6.8%, the highest since 1982.
Some argue those with a low to moderate income are in part insulated from inflation due to government entitlement programs such as food stamps, rent controls and guaranteed access to healthcare. They often also argue that the middle class faces the biggest difficulties from inflation. This is because they don’t typically have government support and they spend a larger portion of their total income on non-discretionary goods like food, electricity, and gasoline. Finally, while the wealthy are impacted, they spend a relatively small portion of their income on non-discretionary goods and can move the capital they don’t spend into assets which “hedge” against inflation. Inflation hedges are typically tangible assets like precious metals and real estate.
Many accept that real estate is an inflation hedge, but few really appreciate why. In this article we will briefly explain the primary reasons real estate, specifically commercial real estate is a hedge against inflation.
Real Estate inflation is usually both cost push and demand pull. As the cost of the components needed to construct a commercial building increase the price of completed buildings increases. As the supply of capital in the market seeking to be invested increases, those dollars chase the same properties, pushing prices up.
First, in the short run there is a fixed quantity of real estate so as buying power declines, real estate will become more valuable relative to the money supply. In the long run real estate supply will increase because it is in times of rising real estate prices that developers tend to become more active, increasing supply to reduce the upward pressure on real estate prices but this can take years and is impacted by many other factors. Because of it relatively fixed quantity, owning commercial real estate hedges inflation by allowing its owners to ride the upward pressure of price increases.
Second, commercial real estate is said to have value for one reason, it can generate a cashflow stream in the form of rent or sales proceeds. When the cost of physical real estate increases, the return on that real estate must increase for it to retain its value and justify its creation. This pressure translates into higher rents.
Third, real estate is durable. Unlike automobiles or consumer products, land has an infinite life and improvements on land last for decades or even centuries. For this reason, as other assets erode and currency loses value, commercial real estate continues to exist and arguably retains its value.
Fourth, inflation is said to benefit borrowers. Simply put, borrowers take loan proceeds in current dollars and pay them back in the future with devalued dollars. Real estate is a sound “home” for debt meaning one can use it to secure a loan with favorable terms. Properly leveraged real estate enjoys enhanced financial returns, generates a cash stream sufficient to service associated debt and can be paid for overtime with devalued dollars.
Finally, the tax code can be more favorable to real estate owners in times of higher inflation. For example, accelerated depreciation which is often used as a stimulus allows commercial real estate owners to take the tax benefit of a portion of their assets, that associated with FF&E more rapidly that would otherwise be allowed. Further, the components of a real estate property can be segregated into shorter lived assets, allowing more rapid depreciation. For this reason, the tax benefit is pulled forward to the early stage of ownership when tax dollars saved have more value.
These five reasons support the idea that commercial real estate ownership can help investors hedge their wealth against inflation. But, understanding this leads to a natural question, how can a person access this hedge.
Commercial buildings can cost 10s of millions of dollars, making them out of reach for even some of the wealthiest Americans. Debt can be used to support 50, 60, even 80% of the cost of acquisition but the remining equity required is still sizeable. For this reason, many alternative forms of ownership have been created, the most viable of which is publicly traded REITs.
In 1960 Congress created the idea of a REIT. As time evolved, many REITs became publicly traded and the REIT modernization act was passed which broadened the business activities REITs could conduct. Publicly traded REITS offer the inflation hedge benefits listed above and offer other benefits such as liquidity and scalability of investment.
REITs were created expressly to allow American’s who were not able to invest millions of dollars to enjoy the benefits of commercial real estate ownership, including the inflation hedging aspects of commercial real estate ownership. According to Millionacres.com, a real estate data website, publicly traded equity REITs averaged a 10.1% total annual return over the 30-year period ending in 2020, making them a viable investment in addition a sound inflation hedge.
Inflation can be simply defined as an increase in the cost of goods relative to the quantity of money in the economy. In my Freshman year at Stetson University, my Economics Professor Dr. Neal Long explained it this way. Inflation is either “Cost push or demand pull”. Cost push inflation means that the cost of creating goods increases, causing inflation. For example, if hourly wages or necessary steel used to produce a product increase, that cost will typically be passed along to consumers in the form of higher prices for the produced good. In a nutshell, end buyers of the goods produced will get less for their money. Demand pull inflation occurs when the quantity of a product demanded by consumers increases but there is not a proportional increase in supply. For example, the classic Dutch tulip bubble was caused by a dramatic increase in the demand for tulip bulbs but there was not a similar increase in the supply of tulip bulbs. Again, consumers get less for their money.
The cause of the current inflationary environment in the US can be debated but whether it is the result of a flood of money chasing the same goods (long term) or a decline in the availability of goods due to short term interruptions in getting goods to consumers (transitory), the reality is that inflation is higher today than it has been in decades. According to The Guardian, the US inflation rate reached 6.8%, the highest since 1982.
Some argue those with a low to moderate income are in part insulated from inflation due to government entitlement programs such as food stamps, rent controls and guaranteed access to healthcare. They often also argue that the middle class faces the biggest difficulties from inflation. This is because they don’t typically have government support and they spend a larger portion of their total income on non-discretionary goods like food, electricity, and gasoline. Finally, while the wealthy are impacted, they spend a relatively small portion of their income on non-discretionary goods and can move the capital they don’t spend into assets which “hedge” against inflation. Inflation hedges are typically tangible assets like precious metals and real estate.
Many accept that real estate is an inflation hedge, but few really appreciate why. In this article we will briefly explain the primary reasons real estate, specifically commercial real estate is a hedge against inflation.
Real Estate inflation is usually both cost push and demand pull. As the cost of the components needed to construct a commercial building increase the price of completed buildings increases. As the supply of capital in the market seeking to be invested increases, those dollars chase the same properties, pushing prices up.
First, in the short run there is a fixed quantity of real estate so as buying power declines, real estate will become more valuable relative to the money supply. In the long run real estate supply will increase because it is in times of rising real estate prices that developers tend to become more active, increasing supply to reduce the upward pressure on real estate prices but this can take years and is impacted by many other factors. Because of it relatively fixed quantity, owning commercial real estate hedges inflation by allowing its owners to ride the upward pressure of price increases.
Second, commercial real estate is said to have value for one reason, it can generate a cashflow stream in the form of rent or sales proceeds. When the cost of physical real estate increases, the return on that real estate must increase for it to retain its value and justify its creation. This pressure translates into higher rents.
Third, real estate is durable. Unlike automobiles or consumer products, land has an infinite life and improvements on land last for decades or even centuries. For this reason, as other assets erode and currency loses value, commercial real estate continues to exist and arguably retains its value.
Fourth, inflation is said to benefit borrowers. Simply put, borrowers take loan proceeds in current dollars and pay them back in the future with devalued dollars. Real estate is a sound “home” for debt meaning one can use it to secure a loan with favorable terms. Properly leveraged real estate enjoys enhanced financial returns, generates a cash stream sufficient to service associated debt and can be paid for overtime with devalued dollars.
Finally, the tax code can be more favorable to real estate owners in times of higher inflation. For example, accelerated depreciation which is often used as a stimulus allows commercial real estate owners to take the tax benefit of a portion of their assets, that associated with FF&E more rapidly that would otherwise be allowed. Further, the components of a real estate property can be segregated into shorter lived assets, allowing more rapid depreciation. For this reason, the tax benefit is pulled forward to the early stage of ownership when tax dollars saved have more value.
These five reasons support the idea that commercial real estate ownership can help investors hedge their wealth against inflation. But, understanding this leads to a natural question, how can a person access this hedge.
Commercial buildings can cost 10s of millions of dollars, making them out of reach for even some of the wealthiest Americans. Debt can be used to support 50, 60, even 80% of the cost of acquisition but the remining equity required is still sizeable. For this reason, many alternative forms of ownership have been created, the most viable of which is publicly traded REITs.
In 1960 Congress created the idea of a REIT. As time evolved, many REITs became publicly traded and the REIT modernization act was passed which broadened the business activities REITs could conduct. Publicly traded REITS offer the inflation hedge benefits listed above and offer other benefits such as liquidity and scalability of investment.
REITs were created expressly to allow American’s who were not able to invest millions of dollars to enjoy the benefits of commercial real estate ownership, including the inflation hedging aspects of commercial real estate ownership. According to Millionacres.com, a real estate data website, publicly traded equity REITs averaged a 10.1% total annual return over the 30-year period ending in 2020, making them a viable investment in addition a sound inflation hedge.