How Rising Interest Rates And Inflation Impact Real Estate Investments

When interest rates rise, mostly in periods of economic expansion, various asset classes react uniquely. Rising rates erode the principal of bonds, affect the value of stocks and other financial assets and influence interest payments on debt.

However, real estate investments have the characteristic of performing well in a rising rate environment. In particular, income-generating real property and multifamily have historically — and as I’ve witnessed from experience as an investor and developer — shown a greater ability to grow net income during expansionary periods than securities and other assets.

Let’s look at our position with inflation and the way real estate is faring under the pressure. 

Looking At Current Inflation Figures

On Friday, Dec. 10, 2021, the Bureau of Labor Statistics stated that the U.S. inflation rate increased 6.8% over the previous year, the largest year-over-year rise since 1982. This figure is a macro reflection of a recent trend in the U.S. economy.

Inflation increased by 0.8% in November, following a 0.9% increase in October, with many commodities (including fuel, food and housing) seeing price hikes for the sixth consecutive month.

The shelter index increased 0.4% over the month, as the indices for rent and owners’ equivalent rent both rose 0.4%. Similarly, according to recent data from the S&P CoreLogic Case-Shiller Indices, home prices in the United States are continuing their upward trajectory, up 19.8% year over year.

Inflation, A Global Effect

As a quick review, inflation is a gradual increase in the price of goods and services in a given market. And once the overall price level rises, each unit of currency buys fewer products and services. Hence, inflation equals a loss of money's purchasing power. The inflation rate — the annualized percentage change in a general price index — is a typical metric of inflation.

Inflation disrupts the economy's pricing systems, and this forces people, as well as firms, to make less-than-optimal spending, saving and investment decisions. Furthermore, when there is inflation, economic players frequently take measures to shield themselves against its detrimental effects, diverting resources away from more productive activities.

In the end, inefficient decisions can diminish earnings, slow economic progress and lower living standards. These far-reaching distortions warrant that inflation is kept low to stabilize the economy and promote the productive utilization of resources.

A Historical Look At Inflation And Real Estate

Historically, real estate has always been considered a strong inflation hedge. Researchers from The Wharton School of the University of Pennsylvania show that in 1979, the consumer price index (CPI) in the United States reached 13.5%, the highest level since 1947. Interestingly, the average dividend income from REITs trading on the stock exchange that year was 21.2%. Additionally, annualized consumer price inflation accounted for 5.1% in the first eight months of 2011. With annualized total returns in this period averaging 8.4%, REIT returns once again safeguarded buying power.

Between 1978 and 2011, REIT dividend increases averaged 7.71% per year, whereas consumer price inflation averaged just 3.92%. For added context, REIT dividend income outperformed inflation in 306 of the 404 months. These dynamics allowed REIT returns to preserve purchasing power throughout this period.

Similar outcomes are recorded on private real estate. According to a 43-year review of the NCREIF Property Index, private real estate total returns were robust during years of inflation. A recent example is the 12 months ending in Q3 2021, when annual real GDP growth and inflation rates were 4.9% and 5.4%, respectively, but the NCREIF Property Index posted a healthy annual rate of 12.1%. 

Real Estate Investment Characteristics During Inflationary Periods

Owning real estate has a number of benefits during periods of high inflation. First of all, owners will see appreciation as property values keep pace with inflation. Also, with fewer real estate development projects due to rising labor, material, machinery and other costs, property supply slumps, leading to more price increases.

Second, inflation pushes all prices upward, rents included. As housing development slows and demand for existing properties rises, occupancy rates typically skyrocket. In such environments, landlords raise rents, which generates higher revenues (and increases property value) — as demonstrated by CoreLogic data, nationwide rents increased 10.2% year over year in September 2021.

Finally, mortgage payments on fixed-rate instruments do not change over time, i.e., the payments remain constant while equity growth accelerates. Furthermore, inflation reduces the value of money owed in the future.

That said, advisors and investors should be aware that as mortgage rates rise during periods of inflation, demand for real estate tends to decline as debt becomes more expensive. The resulting weakening of demand can negatively impact asset prices.

A Positive Outlook

In December 2021, CBRE research found, “Despite uncertainty from the omicron variant and other risks, a growing economy will fuel demand for space and increase real estate investment across all property types.”

Inflation in the U.S. hit multidecade highs in 2021, mainly due to robust economic growth, workforce shortages and hampered supply chains. Nonetheless, according to CBRE, interest rates will not rise sufficiently to harm real estate markets, with the 10-year Treasury yield forecast to hit 2.3% by the end of 2022 (up from 1.4% in early December).

Next year’s outlook for real estate is positive, though. In particular, U.S. multifamily investment volume is expected to exceed $234 billion in 2022, or a 10% increase over 2021, continuing its strong recovery. 

To recap, in a volatile global market, privately owned, high-quality real estate with stable income streams can constitute a prime allocation choice. Besides delivering relatively high yields, low volatility and several portfolio diversification benefits, real estate has consistently been favored by advisors and investors due to its ability to weather inflationary pressures while preserving and building value.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

SOURCE: Forbes.com