It's no secret that investing in real estate is one strategy for accumulating wealth. Over time, property owners have seen impressive gains in many markets. This is particularly true in those areas where there is a skyrocketing demand for housing and a lack of available new units. Some of the world's richest magnates have made their wealth by developing new housing projects. But does real estate provide the average investor with profitable opportunities during times of high inflation?
Takeaways
What is an inflation hedge?
An inflation hedge is an investment or asset that maintains its value or increases in value during inflationary times. The goal of an inflation hedge is to defend the investor from the decline in the purchasing power of money. This occurs when prices of goods and services rise rapidly. The best hedge not only offsets the mathematical losses to inflation, but it also outpaces it with a greater amount of growth.
Advantages of investing in real estate as an inflation hedge
The first advantage of real estate as an inflation hedge is its long-term appreciation of value. Despite some historic downturns real estate has continued to gain in value. This is despite losses during the global financial crisis of 2008.
Real estate also has the advantage of providing investors with recurring rental income from tenants. When property prices go up, this benefits landlords because higher property prices generally lead to higher rents. This recurring income can also help property owners ride out times when the market suffers a decline.
Additionally, real estate investors can benefit from the impact inflation has on debt. As property prices rise, investors will see an increase in their equity. If they hold a fixed-rate mortgage on the property, their payments will remain the same. This is whilst the value of the property has increased.
In some cases, there can be significant tax benefits to real estate investors. This includes expense deductions, depreciation of costs, deferred taxes, and long-term capital gains.
Disadvantages of investing in real estate as an inflation hedge
The above said, real estate investing isn't a completely perfect hedge. It does come with some notable handicaps.
First, real estate can take a significant amount of time to liquidate. Some markets can be extremely hot, selling properties in what seems like lightning speed. Unfortunately, the paperwork and regulations still typically take at least 30 days or more to complete. So, unlike stock, bond, or mutual fund shares that can be sold and turned to cash in minutes or a day at the outside, real estate is slow to buy and sell.
Second, real estate transaction costs can be quite high. In the United States, property sellers pay a 5% to 6% commission on the sale price of a home, which is split between the buyer's and seller's agents. Both buyers and sellers will face an array of transaction costs, including escrow, title, and inspection fees.
Maintenance, taxes, and debt service can also take a huge bite out of profits. Property owners will need to set aside money for repairs. If the property has a mortgage, they will need to pay interest on the mortgage and, in some cases, mortgage insurance to protect the lender in case of default. They may also need to pay for other types of insurance—such as earthquake, flood, fire, and liability insurance.
How to use real estate as a hedge
While many investors think of residential properties when considering investing in real estate, there are other ways to gain exposure to the asset class. Here we discuss the pros and cons of several types of real estate investments.
Commercial real estate
Investors in commercial real estate buy business-related properties that produce rental income and have a potential for capital appreciation. Examples include retail and office buildings, apartment buildings, warehouses, and industrial buildings.
One of the limitations of commercial real estate is the entry costs for a single investor are high. Because of this, many commercial investors form partnerships which spread the cost impact over several parties. In ideal situations, these deals can generate considerable rental income that can more than pay for financing and maintenance costs.
The biggest downside to commercial real estate is that it is often a high-risk investment. It can be a long time before the investor achieves a profit and some projects fail entirely. Many successful investors have substantial knowledge of the industry and are familiar with construction, development processes, and government regulations.
Real estate investment trusts (REITs)
REITs offer investors the ability to invest in a company that directly purchases, operates, and finances real estate properties for short and long-term gain. Compared to direct investments in residential and commercial real estate, REITs can be a much easier way for investors to get started.
Investors can start with a small investment stake and can conveniently buy and sell REIT shares on the major stock exchanges. REITs combine the capital of many investors and purchase various property types—such as hotels, apartment buildings, offices, data centers, and warehouses. By law, REITs must pay 90% of their profits as dividends to shareholders.
The success of a REIT depends on the expertise of the company managing the trust and what properties they decide to make part of the REIT pool. Some REITs have high management fees. Additionally, REITs offer little in the way of capital appreciation since most of their income must be paid as dividends to investors, leaving very little for investment in new properties.
REIT exchange traded funds (ETFs)
Investors who prefer not to risk money on an individual REIT might opt for a REIT exchange traded fund (ETF). A REIT ETF consists of investments in various types of REITs and related derivatives. A REIT ETF passively tracks real estate sector indexes. They offer high dividends and low expense ratios.
Real estate mutual funds
Like REITs and REIT ETFs, mutual funds provide investors the ability to join large pools of real estate investment. Mutual funds are actively managed by portfolio managers who trade the value of the pool in various positions.
While most mutual fund managers focus their investing on their target area of the market, they rarely buy real estate assets directly. They may invest in other funds, REITs, trusts, partnerships, or companies who own real estate, investing on a business' performance versus the real estate itself.
A drawback to real estate mutual funds (along with REITs and REIT ETFs) is that the approach is not well diversified and can be volatile if the real estate market declines. When the real estate market falls, these investments will likely fall as well.
Real estate crowdfunding
A newer option for real estate investing involves jumping into a crowdfunded pool with other individuals via the Internet. Developers use social media to connect with networks of people and solicit investments for their real estate projects. An advantage to investors is the chance to invest a small amount—sometimes as little as $500 to $1,000—on any given project.
There are several drawbacks to real estate crowdfunding. These can be high risk ventures that may take years (if ever) to become profitable. A novice investor may find it challenging to determine if a particular deal is a legitimate investment with the potential to turn a profit.
You may need to be an accredited investor with a net worth of at least $1 million. The U.S. Securities and Exchange Commission (SEC) has instituted crowdfunding regulations aimed at protecting investors and providing rules governing crowdfunding companies.
Conclusion
In short, real estate investing can offer a rewarding hedge against inflation when combined with careful research and risk evaluation. There are multiple ways to get into real estate investing, each one with advantages and disadvantages for different investor types.
However, remember that real estate is only one option when fending off the impact of inflation. Other alternatives exist as well, from gold to Treasury Inflation-Protected Securities (TIPS) to commodities. Many investors diversify across a spectrum of the economy to take advantage of different shifts and changes over time.
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