During the last year, inflation increased more rapidly than it has since 1982. The Consumer Price Index (CPI) spiked 6.8 percent year-over-year, beyond the projections of leading economists in the U.S. The price of nearly all consumer products and services increased significantly. In these uncertain economic times, more investors are turning to multifamily apartment investing to stay ahead of the financial perils of inflation.
It is true that the onset of fast-paced inflation can strongly impact all types of investing. Commercial real estate, including multifamily apartment properties, are affected by increasing inflation. Yet, multifamily property owners can reduce the ill effects of rising inflation for investors.
Three Major Types of Inflation
Consumers know well that as inflation increases, the purchasing power of consumers decreases. The three primary types of inflation and their causes are the following:
- Cost-Push Inflation. With this type of inflation, as companies experience rising costs, they pass these costs on to the consumers. These cost increases to businesses may be due to higher prices for materials, such as oil, steel or lumber. They may also be based on the rising price of labor. In the real estate industry, cost-push inflation can occur when a shortage of commercial real estate occurs, requiring companies to pay higher rents.
- Demand Inflation. This form of inflation occurs when the supply chain cannot keep pace with a rapidly increasing demand for certain goods. Demand inflation is often initiated when consumers have enough discretionary income to pay higher prices for these products or services (and do so).
As inflation rises, the Federal Reserve Bank typically begins to raise interest rates. The rising interest rates then cause the cost of debt to escalate.
- Inflation Due to Government Money Printing. The federal government may print more money to strengthen the economy and create more available jobs. The government can print more money and put more money into circulation by boosting government debt. They may also allow banks to issue larger loans on a given security.
Yet, with more money in circulation, the value of each note begins to decrease. Instead of strengthening consumers’ purchasing power, more money in circulation raises prices.
Although economists advise that some amount of inflation can benefit the general economy, a rapid rise of inflation can create problems. This is especially true when workers’ wages do not show a similar degree of increase. Since costs, prices and wages very rarely increase or decrease simultaneously and at the same rate, this imbalance can initiate a serious disruption in the economy.
Effects of Inflation on Multifamily Real Estate
During past years, the inflation rate has remained in the range of from two to three percent each year. This fact enabled multifamily property investors to obtain extremely low-cost debt, supporting the multifamily apartment market at the onset of the Great Recession of 2008.
For the duration of the major Covid-19 pandemic, the Federal Reserve Bank reduced rates still more to stimulate the economy. This helped avoid a similar economic fall to that of 2008 to 2010.
With a stable economy today, inflation is currently on the rise at a fast pace. This rapid increase in the rate of inflation will have a powerful effect on the multifamily real estate investing market. These high rates of inflation are expected to affect the multifamily property investing market in the following ways:
- Upswing in Construction Costs. During cost-push inflationary times, construction costs typically increase. This effect then drives up the overall cost of construction. If a shortage of skilled laborers also exists, it becomes more expensive and time consuming for contractors to hire the necessary construction crews, adding to the overall cost of building.
The National Association of Home Builders (NAHB) reports that construction material prices spiked to 26.1 percent from June 2020 to June 2021. This percentage is the highest ever resulting from a survey by the NAHB. The highest previous level on record at that time was 6.1 percent, recorded in 2017.
During the same period in 2020-2021, there was a serious shortage of construction workers. A little-known fact, in general, is that 740,000 new workers are needed each year going forward. Only if this number is recruited will the supply be acceptable for demand in this industry sector.
- Decrease in Multifamily Apartment Inventories. In some market circumstances, the rental rates that a multifamily apartment developer can charge do not offset the high cost of new construction. This means that fewer new multifamily properties will be built, and the inventory of these properties will decrease.
During the height of the Covid pandemic, however, multifamily apartment construction outperformed other real estate asset classes. This high performance continues today as the economy gains stability and inflationary economic conditions prevail and rise. Current reports indicate that from 450,000 to 500,000 new apartment buildings and complexes must be constructed every year to meet the demand of today’s growing household numbers.
- Increase in Prices. With high inflation, prices of multifamily apartment properties typically increase. This price increase affects both newly built buildings or complexes and currently existing ones. Escalating construction costs cause property developers to push prices higher on new buildings.
At the same time, with the supply of multifamily real estate decreasing, pricing for existing buildings rises. Investors then become more competitive, boosting prices for multifamily apartment assets even higher.
- Debt Expense Escalates. During the past few years, multifamily real estate investors had enjoyed the advantage of low-cost, fixed-rate debt of +/- 3.0 to 3.85 percent. This low-cost debt enabled more investors to afford multifamily properties. This resulted in price increases for these multi-unit buildings. It also often made it possible to finance needed improvements to these properties at a lower cost, adding value to this asset class.
If an inflationary period exits, debt can increase significantly in cost. Even if interest rates head upward moderately, the price of investing in multifamily apartment properties or upgrading these buildings with improvements will rise.
- Back-off by Investors. The escalating costs of investing in multifamily apartment assets will cause some investors to retreat. This can leave more properties available for other investors who are staying in the game, so to speak. Yet, this retreat may also create a quieter, less active market for these properties.
However, this real estate market segment of multifamily buildings has long-enduring sturdy fundamentals that will encourage other investors to keep buying and expanding their portfolios.
Performance of Multifamily Properties as an Inflationary Hedge
When examined over time, reports show that multi-unit apartment buildings with private ownership had higher performance levels than any other commercial property asset class. During times of high inflation, this real estate type had performance levels equal to more than 5 percent.
In comparisons of privately-owned multifamily real estate to the stock market and U.S. equity apartment REITS, the multifamily property assets won leading notice for higher performance. Meanwhile, both the stock market and the REITS showed poor financial returns.
Further analysis revealed that following the Global Financial Crisis, an increase of one percent in inflation indicates a 1.20 percent upswing in private commercial real estate (CRE) excess returns. Yet, during the same time period, a one percent increase in inflation indicates a reduction in the financial returns of both stocks and REITS. In addition, private apartment buildings in the U.S. show an impressively higher result for average risk-adjusted returns.
Owners Use Multifamily Apartment Properties as an Inflation Hedge
Multifamily apartment building owners use these properties to hedge against inflation in the following ways:
- Raising Rents. By increasing annual apartment rents by the yearly inflation rate, multifamily property owners can effectively hedge against inflation. There can be fairly fast tenant turnover in apartment properties with leases that must be renewed every year. When new tenants sign a lease, landlords are allowed to raise rental fees by no less than the annual inflation rate.
- Aligning New Lease Rental Rates with CPI Increases. Landlords of multifamily apartment real estate may decide to rewrite their leases to align with the Consumer Price Index (CPI). These revised leases should clearly explain that annual rent raises will be equal to or higher than the annual adjustment to the CPI.
Since the CPI is the main benchmark for measuring inflation, it can serve as a reference point for justifying potential sharp rent increases in the near future, if needed.
- Negotiating New Vendor Contracts. By renegotiating existing contracts with vendors, landlords of multi-unit properties can lock in prices for one to three years, and sometimes more. Any future improvements that are needed during this time frame can be completed at a lower cost. This also helps property investors to hedge against current and future cost increases.
Savvy investors in multifamily apartment properties today are gaining attractive financial returns during the current period of high inflation. Although they are increasing somewhat, interest rates are currently at significant low levels. Multi-unit property investors who lock in long-term, fixed-rate debt at current low interest rates have a definite advantage in today’s REI market.
Investors in multifamily real estate during the height of the pandemic made a wise and profitable choice. These properties continue showing high-performance rates today while the economy gains stability and inflation increases. Any property investors seeking an effective hedge against inflation should strongly consider acting now to add multifamily apartment properties to their portfolios.