Why Income-Generating Real Estate Is The Best Hedge Against Inflation
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Patrick Grimes is the founder of Invest on Main Street, a private equity firm managing passive multifamily investments in emerging markets.
Everyone is talking about inflation these days. Knowing that products and services you buy are going to cost more can be frightening, especially if you’re locked into an income that doesn’t keep pace with inflation. Paying more for toothpaste may be the least of your worries, as retirement accounts take the biggest hit when the value of the dollar decreases.
If you’re concerned about what inflation can do to your retirement dollars, it may be time to consider inflation-hedging investments. Unlike stocks, bonds and mutual funds, investing in real estate can make inflation actually work for you, increasing your income as inflation rises.
While real estate investing is a proven wealth-building tool, most busy professionals don’t have time to be DIY landlords dealing with tenants, toilets and trash. However, it is possible to achieve the same inflation-hedging advantages without the headaches by investing passively through private-equity-firm-sponsored real estate syndications.
What Is Inflation?
Inflation is a decrease in the purchasing power of a dollar. What a dollar could buy in 1950 now takes $10 to purchase today. Inflation is caused by a number of overlapping factors. For example, during the Covid-19 pandemic, we saw inflation raise the price of goods and services as supply chain issues negatively affected production and delivery. But global pandemics aren’t the only things that cause inflation. Supply and demand, fiscal policy, corporate policy and manufacturing costs can all lead to inflation.
Inflation Can Diminish The Purchasing Power Of Retirement Accounts
Where inflation is truly dangerous to the average person is in retirement savings. It can be the slow silent drain that reduces the purchasing power of retirement dollars.
While the Federal Reserve believes that a 2% inflation rate is an indicator of a healthy economy, as of February 2022, inflation had risen to 7.9%. Let’s look at an example. Say that many years ago you placed funds into your 401(k) or IRA and allocated it to stocks. From 1999 to 2019, returns of the S&P 500 averaged 5.9%. This means that today, due to inflation, you would barely break even and should expect a loss after paying taxes. In addition, in years past, inflation in the US has risen to levels above 20%. The higher the rate of inflation, the more purchasing power you lose over time, even as the dollars in your accounts increase.
People who plan to fund their retirement with IRAs, 401(k) plans and savings accounts can be devastated by the long-term effects of inflation. One way to hedge against this is to invest in real estate.
Your Mortgage Costs Less Over Time
The first and perhaps most important step toward inflation hedging is to buy your own home with a fixed-rate mortgage. If you are renting, you’re not only building someone else’s equity, you’re also subjecting yourself to inflated yearly rent increases.
When you buy a property with a fixed-interest mortgage, your monthly payment is based on the value of the dollar at the time of purchase. As you make payments over the years, you’re paying with cheaper dollars as inflation rises.
For example, if your mortgage payment is $1,000, those dollars will buy 200 loaves of bread today. In 20 years, your payment will still be $1,000, but that may only buy 50 loaves of bread. During those 20 years, your wages continue to rise, so that $1,000 payment feels like less of a financial burden. The more inflated the dollar, the easier it is to make your mortgage payments in the future and the harder it is to pay rent.
Income-Producing Properties Can Make Inflation Work For You
One thing that generally keeps pace with inflation, and even surpasses it, is rental income from investment property. In fact, in our current inflationary environment, rents in certain desirable cities have increased 30% in the past year. With a fixed-rate mortgage, loan payments stay the same, which creates a spread (more rental income) between rising rents and the cost of your mortgage payment.
Expenses such as insurance and taxes also inflate, however, income-producing real estate tends to have higher rental income than expenses. In our multifamily apartment buildings, for example, expenses are typically half the rental income. When inflation grows, a smaller expense bill is often outpaced by the leap in income caused by growing rent checks. Oftentimes, this effect can drive greater cash flow and profits in an inflationary environment.
The Many Ways To Invest In Real Estate And Hedge Against Inflation
The majority of people I speak to have socked money away into IRAs and 401(k) plans and now don’t think they have funds to invest in real estate, but this is a common misconception. Investors can roll a portion of their funds over into a self-directed IRA or 401(k) and use those funds to invest in real estate.
When it comes to investing in income-generating properties, investors have two primary options. One is direct purchases, typically single-family homes, which requires a significant learning curve and work to drive good returns and manage the investment.
The second is through investing passively with a private equity firm that sponsors syndications, where investors can purchase a share of a large commercial asset or invest in a portfolio of properties. These don’t require any know-how or active management for the investor, and they allow investors to benefit from the greater tax advantages of larger commercial assets.
Protecting Yourself Against Inflation Is A Smart Move For Your Future
When it comes to investing for your future, considering the effects of inflation on your assets can help you mitigate inflation before it drains the purchasing power in your retirement accounts. By investing in income-generating real estate, you can hedge your bets against inflation and protect your retirement dollars long-term.
The information provided here is not investment, tax, or financial advice. You should consult with a licensed professional for advice concerning your specific situation.