Have you ever heard someone say that real estate is a good hedge against inflation?
This is one of those statements I heard often when I first started learning about real estate investing. Truthfully, I wasn’t even sure what hedge really meant. It’s like “hedging your bets,” someone once explained to me. I don’t gamble and the only image I had was someone trimming hedges. Now that couldn’t be right!
With google at my side, I learned that to hedge one’s bet means to take action to protect against a loss. So to hedge against inflation must mean to protect against inflation. Inflation would cause some loss so to hedge against it would be to prevent it.
Now I’m getting somewhere! I love you Google. Now this is just scratching the surface. Next up, inflation!
In this post, I want to explore whether or not real estate values are a good hedge (i.e. offer protection) against inflation.
What is Inflation?
Back in 1954, you could go to a movie theater and watch a film if you had just 2 quarters in your pocket. In 1985, that same ticket on average cost $3.55. By 2015, the average movie ticket price has jumped to $8.43.
The same price rise can be seen in food costs such as the classic American cheeseburger. Accounting for the bread, lettuce, tomato, 1 slice of American cheese, and a quarter pound beef patty would run you $0.64 back in 1985 according to the Bureau of Labor Statistics. 30 years later, that same burger would cost you $1.74 in 2015.
So a cheap homemade dinner and a movie date (no popcorn) has more than doubled since 1985, costing you just over $10 now versus under $5. Better sneak in some candy and a drink to the movies.
So what happened over this time period?
From Wikipedia, inflation is defined as follows:
Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time.
The cost of goods and services rises over time caused by a devaluation of currency. In other words, the purchasing power of a dollar has gone down over time. So a single dollar bill in 1954 could have purchased 2 movie tickets. Not in today’s world though, where $1 wouldn’t even pay for a drink at the movies, let alone a single ticket.
How is Inflation Measured?
In the US, the most widely used measure for inflation is the Consumer Price Index (CPI). Published every month by the Bureau of Labor Statistics (BLS), the CPI measures changes in price paid by consumers for a representative basket of goods and services.
The CPI is essentially a massive survey conducted by the BLS. Each month, data collectors at the BLS visit or call thousands of retail stores, service establishments, rental units, and doctors’ offices, all over the United States, to obtain information on the prices of the thousands of items used to track and measure price changes in the CPI. In total, the prices of about 80,000 items are recorded each month, representing a scientifically selected sample of the prices paid by consumers for goods and services purchased.
Comparing CPI and Home Prices
Now getting back to linking inflation with home prices. We want to address whether real estate is a good hedge against inflation. In other words, have home prices kept up with the rate of inflation? Or have home prices rise at a faster rate than inflation? To answer this question, let’s look at how CPI and median home prices have tracked historically.
This graph shows the median home sale price and CPI-U relative to their January 1983 values. The rate of growth of inflation as represented by the CPI is shown by the red line. The median home sale price across the nation is represented by the blue line. I chose to compare home values and inflation based on their 1983 values. Why? Well, the BLS normalizes their inflation index based on average values between 1982 to 1984. Also, the CPI index I’m using is the CPI-U, which is the broadest and most comprehensive index used to capture all consumer items.
As seen in the above graph, home prices and CPI (i.e. inflation) correlate fairly well from the 1960s to the mid 1980s. Starting in the late 1980s though, home prices (red line) began to outpace the rate of inflation (blue line). Then in the early 1990s, home prices slow their growth and falls closer to the CPI growth rate. In the late 1990s, once again home prices surge ahead of the CPI and steeply outpaces inflation during the last real estate bubble. Prices popped in 2008, bringing home prices down significantly. However, in recent years it can be seen that home prices are once again rising much faster than the CPI.
Let’s summarize the key takeaways from this graph.
- Home prices and CPI correlate fairly well for most periods except during recent real estate bubbles.
- Home prices have risen faster than the CPI (i.e. inflation) for the last 30 years.
- Home prices have been much more volatile, experiencing many ups and downs (i.e. can you say bubble?), whereas CPI has exhibited more steady growth.
What’s Not Affected By Inflation?
Regarding home expenses, our property taxes, insurance rates, materials, and labor costs for maintaining a home will all rise over time due to inflation. On the other hand, so will the rents charged for investment property. It seems everything is affected by inflation. Is there anything that’s not affected by inflation?
Say hello to fixed interest loans.
A fixed interest rate loan means that our debt payments stay the same over the life of the loan. So in the future, we still make the same monthly payment, but because of inflation, the dollars used to pay back that loan are worth less
Let’s look at a hypothetical example.
A $100,000 loan fixed at 5% annual interest over 30 years results in a monthly debt payment of $537. This payment will never increase over the course of the loan. Take a look at the hypothetical cash flow numbers below. I’ve assumed a starting monthly rent of $1300, 50% rule for expenses, and a 3% increase in both income and expenses due to inflation.
Did you notice what remains constant across each year?
The debt payment stays fixed at $537 whether it’s year 1, year 5 or year 30! Over the course of the 30 year loan, you can expect every thing else in our cash flow equation to grow because of inflation. The property’s income (i.e. rent) and expenses will both increase, but the debt payment stays the same! Therefore, cash flow increases!
Not only does the debt payment stay the same, but we’re actually paying the loan off with dollars that are less valuable in the future. Due to inflation, we know that the purchasing power of a dollar today will be far greater than a dollar 30 years from now. So imagine we had purchased this property in 1986 and had a mortgage payment of $537 back then. Fast forward 30 years to 2016 today and we continue to make that $537 payment. The purchasing power of $537 in 1986 would be equivalent to $1,181 in today’s 2016 dollars. Does our mortgage payment jump up to this $1,181 value? Nope. We just keep making the same $537 payment!
In essence, by utilizing leverage investors can gain greater cash flow by paying back their debt with cheaper dollars in the future!
Inflation affects all goods and services including real estate. A dollar loses its purchasing power over time and takes more dollars to get the same good or service. We want to invest in assets that keep up with or outpace inflation. In other words, we want to invest in assets that hedge (i.e. protect) against inflation.
So is real estate a good hedge against inflation? I think so. Home prices on a macro scale appear to at least keep up with inflation and in recent years has outpaced it. Not only that, but if you’re using leverage, then you further benefit by making fixed debt payments with future inflated (i.e. cheaper) dollars. So while inflation will cause rents and expenses to rise over time, your debt payments remain fixed.
A nice hedge indeed.
Have you seen home prices increase faster than inflation in your market?
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