Dealing with inflation can be a real hassle for your personal finances but don’t underestimate the big role it plays in your real estate investment strategy. On the positive side, it can result in substantially higher rent growth and profitability for your investment. But for folks who are invested in debt-financed passive real estate, it’s very important to understand the negative impacts of debt inflation on your investment. This understanding will help you protect and grow your investment portfolio. In this blog, we will explore key factors to take into account when investing in real estate during inflationary times.
Rent Inflation Is Great Boon to Property Valuations
Investing in periods of high inflation can be very profitable. With the household relocations and expansions driven by Covid, we just experienced a few years of exceptional rent growth and project profitability. According to Yardi Matrix, their survey of 140 markets exhibited rent growth of 15% in 2021 and 6.2% in 2022, compared to historical annual growth of 3-4%. This resulted in many projects going full cycle (hitting their business plan) in 3-4 years instead of the 5 year plan, or projects going full cycle in 5 years with much higher profitability than projected.
Multifamily is a great investment category during inflationary times because rents can be adjusted typically every 12 months, or less. That means operators can react to market conditions to protect and enhance property profits, whether the need is to adjust pricing to cover rising operating costs or to stay current with market-driven rents that rise to reflect increasing demand.
What are Interest Rates Doing?
When investing during inflationary periods, what you should first consider is the prevailing interest rates in the debt market and which direction are they headed. Market rates for properties may be higher due to inflation, and investors must face this reality when evaluating potential deals. But the key question is where those rates might be headed and what kind of debt is on the deal.
For example, interest rates might be projected (no one will know for sure) to increase over the life of the project but if the project has a fixed rate mortgage, debt inflation will not be a factor in the cashflowing of the property. However if that project has adjustable rate debt, then it will be critical to have plans in place to protect against the possibility of much higher interest cost. That protection can be in the form of a rate cap insurance policy that will pay interest costs above a certain interest rate, and/or by the project having extra reserves to cover the higher interest costs. Without this protection, the project could have trouble paying the monthly debt obligation, leading to capital calls or worse.
To ensure the viability of a deal, investors must factor in current and projected higher interest rates and make sure the deal has strong fundamentals and a mitigation plan to protect against the possibility of higher interest rates. If a potential deal does not have a fixed rate or a mitigation plan for adjustable rate debt over the course of the investment, it would be prudent to explore alternative lower risk investment options to execute your financial strategy.
The Relationship Between Interest Rates and Property Valuation
Another impact of interest rates is the effect on property valuation. In times of high debt inflation (like now with interest rates increasing over 5 points in a bit over a year), property values may not keep pace with the rising cost of living. In fact, property values often decline during periods of significant inflation.
In the commercial real estate business, you will hear that “cap rates tend to increase when interest rates increase.” If you will recall, cap rates (how the commercial marketplace values properties) move inversely to property values, so to put it all together, higher interest rates lead to higher cap rates which leads to lower valuations. Therefore, investors must conduct thorough research and understand the debt and market conditions in the regions they are considering for investment.
However, it’s important to bear in mind that real estate valuations have historically exhibited an overall upward trend, despite brief periods of value dips. Over the past two decades, the average annual return for the S&P 500 Index has been around 10 percent. The real estate sector has demonstrated similar growth, even considering the significant drop in housing prices during the 2008 financial crisis. Real estate is an asset that holds its value and tends to rebound over the long term, making it a resilient investment option.
Things to Look Out for in Investment Opportunities
When evaluating real estate investment opportunities, it’s essential to recognize that a deal’s viability hinges on accurate and comprehensive financial analysis. The property’s price tag alone does not determine whether it’s a good investment. Instead, investors must ensure that the deal’s underwriting accounts for the current interest rates in the debt market and other critical factors.
Investors should exercise patience and carefully assess the deal’s dynamics instead of rushing into an investment. Understanding the real numbers today, such as projected rent increases or expenses, is crucial for making informed investment decisions. But now, with so many properties negatively impacted by interest rates that rose rapidly, investors are being reminded vividly that interest rates are a critical factor to consider, and monitoring the markets is essential for understanding the context of any investment opportunity.
Real estate investors must be well-informed and adaptable when navigating inflationary times. Understanding the relationship between inflation and rent growth, interest rates and property valuation, historical returns for real estate, and critical investment considerations can help investors make sound decisions.
These things may sound like a lot to take in and can take so much time to study. However, it gets easier through experience especially if you also have access to expert insights. At GrowAbility Equity, we are committed to providing guidance and support to help you achieve your financial goals. Schedule a wealth acceleration call with us to receive personalized advice based on your specific situation and risk tolerance.
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