The Bureau of Labor Statistics reports that the Consumer Price Index (CPI), a measuring stick of inflation, has gone up 5% in the past year. Compare that to the past 30 years, when inflation has devalued the US dollar by an average of 1.8% per year according to Statista.
Consumers are starting to feel it too, pinched by elevated costs at the pump, at the grocery store, when they travel, etc.
Why is this happening, and what should the average investor do about it?
Let’s take a moment to understand what inflation is, why economists and consumers alike are so worried about it, and why commercial real estate investing may be the key to protect your wealth and income during a period of high inflation — like the one we might be entering now.
What Is Inflation?
Inflation refers to a decrease in the purchasing power of a currency. For example, economist Paul Krugman points to the example that the price of milk averaged $0.36 a gallon in 1913. One hundred years later, it had increased in average cost nearly tenfold, to $3.53.
It may sound quaint when elders wax nostalgic about the low prices of yesteryear. But why does this happen?
The cost of goods and services respond to the laws of supply and demand. So what happened? Did milk become ten times more scarce in the preceding century? Did society get ten times more obsessed with milk consumption?
No. The purchasing power of the dollar decreased, meaning it required more dollars and cents to purchase the same product at the grocery store.
The US dollar has suffered inflation for 59 out of the last 60 years. For people whose “investing” strategy was to hoard cash in a bank account or under a mattress, this means they have actually become significantly poorer over time.
The number of dollars they own may not have changed … but the purchasing power of each one of those dollars has decreased. They can’t afford nearly as many goods and services with that same amount of money as they did when they saved it. And even if they added to their savings over time, it’s like rolling a rock up a hill — gravity is working against you.
What Causes Inflation?
What causes this effect? Two major forces.
During times of high economic activity, the demand for goods and services goes up. The materials needed to produce those goods and services come into heavy demand and may even become more scarce.
Similarly, a booming jobs market, with more open jobs than there are candidates, leads to competition for the best workers, which drives wages higher.
On the hook to pay more in materials and wages, companies are forced to raise prices, decreasing the purchasing power of the currency.
Modern monetary theorists call it “quantitative easement.” Others call it “printing money.” But when the supply of currency increases, it becomes less valuable because it decreases in scarcity. If this sounds threatening, realize that this effect is baked into the cake of our monetary system. The Federal Reserve aims for a debasement of the dollar averaging 2% per year.
What Caused the Current Inflation?
Many factors contribute to inflation, but we can’t ignore the impact of the COVID-19 pandemic. It drove both factors behind inflation.
The government has injected trillions of dollars of economic stimulus into the economy, increasing the supply of dollars in circulation. As the economy reopened, consumers went into a buying frenzy, driving up the demand for goods, materials, and labor.
Simultaneously, reopening employers have experienced a hiring crunch, with too few applicants for the open jobs, leading to competition and increased wages.
In other words, we’re looking at an inflationary perfect storm — rising costs of materials, rising costs of labor, and increased supply of currency, all feeding into decreased buying power for the dollar.
How is Inflation Tracked?
Inflation is tracked primarily by two metrics:
- The Consumer Price Index (CPI) - A measure of the changes in cost over time of consumer goods and services.
- Personal Consumption Expenditures Price Index (PCE) - A measure of how much a household consumes over time.
What Does It Mean to “Hedge” Against Inflation?
To “hedge against inflation” is to acquire assets expected to outperform inflation.
Remember how the hypothetical person who stashed cash under a mattress 60 years ago and never touched it is actually poorer now due to inflation, even if he never touched the stash?
More savvy investors look for capital-allocation opportunities that might grow in value faster than inflation can take away their value. In other words, they get wealthier over time, even in times of inflation.
What Asset is the Best Hedge Against Inflation?
Some investors advocate for the “safety” of bonds but fixed-income debt instruments actually tend to lose value in periods of inflation.
Stocks tend to do better, but real estate tends to outperform them all.
Why is Commercial Real Estate Such a Good Hedge Against Inflation? Why did real estate vastly outperform other popular asset classes in times of inflation?
This effect can be attributed to several factors:
Real Estate is a Hard Asset
Assets can be categorized as hard assets or soft assets. A hard asset has intrinsic value, whereas a soft asset only has market value.
What has intrinsic value — that is, value that exists regardless of hype or market opinion? Usually, we’re talking about something that is:
- Universally tradeable
- Limited in supply
- Can be used to produce goods and services
- Fulfills a basic human need
Several assets fall into this category—precious metals, commodities, natural resources, and real estate.
Gold is universally tradeable—every society in history has regarded it as currency—and it can be used to produce goods and services. Ditto natural resources like oil and gas. Commodities like corn and cattle fulfill a basic human need for food. All of the above is in limited supply.
Real estate, too, is in limited supply. You can print more money or split a company’s stock … but no one can create more land (short of leveling a mountain or waiting for a volcanic island to form).
Furthermore, the structures you build on that land have their own limitations—space, use, height—that create a different kind of scarcity within the asset class.
Finally, real estate fulfills basic human needs—shelter, agricultural land, commercial space in which to do business.
Why does this matter? Because hard assets tend to increase in value with costs. After all, they are the materials for the goods and services people have to pay more money for. In addition to milk and gas at the pump, people have to pay more rent or pay more to buy property. In other words, decreases in the purchasing price of the dollar increase the value of real estate.
Commercial Real Estate is a Unique Hard Asset that Produces Passive Income
Real estate may be a hard asset, but so is gold, oil, and other commodities. What sets commercial real estate apart as a hedge against inflation? Won’t they all increase in value as the CPI and PCE ratchet up?
Yes…but commercial real estate is unique in its ability to generate rental income and create passive cash flow. You can’t really charge rent on a bar of gold or a barrel of oil.
Commercial real estate not only produces rental income but as mentioned above, during periods of inflation market rents tend to increase — thereby increasing the cash flow even more.
Real Estate Leverage Improves its Performance Against Inflation
Finally, commercial real estate performs so well during periods of inflation due to investors’ widespread use of leverage — in this case, commercial mortgages.
Inflation doesn’t cause your loan balance to get bigger on paper … but it does cause the debt to become less valuable, meaning what you owe the bank is less valuable too.
Let’s say an investor borrows $1 million to buy an apartment complex, and the CPI increases 5% like it did last year. The bank can't turn around and claim that the investor now owes them $1.05 million. They’re stuck with that collectible balance of $1 million, which now has the buying power $1.05 million had last year.
Add to that the increasing value of the property due to inflation, and we see the value of commercial real estate increasing, while the price index of the debt decreases. Commercial real estate investors thus benefit from inflation on both sides of their balance sheet.
If the outsized inflation of the past year becomes a trend instead of an outlier, we expect to see the interest in commercial real estate increase over time, even as prices increase. Investors are sheltering and will continue to shelter their wealth in the asset class that outperformed all others during the inflationary cycles of the past.
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