How to hedge against inflation with real estate investments

March 9, 2022

The federal government has committed roughly $13 trillion ($13,000,000,000,000) on pandemic-related spending since early 2020.

These trillions of dollars have to come from somewhere. Some money spent by Congress will have to be borrowed, but the Federal Reserve will ease create some by simply lending the government money out of thin air. Read: printing money, even if it happens through digital ones-and-zeroes rather than a printing press.

All that new money has sent inflation skyrocketing 6.2% from October 2020 to October 2021, the fastest pace in 31 years. And the supply chain bottlenecks and labor shortages sure haven’t helped.

So, what’s an investor to do, to prevent their greenbacks from losing all their value?

A (Quick) Overview of Inflation

Around 30 years ago in 1991, one dollar was worth more than twice today’s dollar. Play around with the BLS inflation calculator to get a sense of the power of inflation for yourself.

The average cup of coffee cost $1.49; today, people blow several times that on Starbucks. The purchasing power of a million dollars today only required about $500,000 back then.

When people are willing to pay more money for goods and services, their cost goes up. The more money is available in the economy, the more people are willing to spend, driving up costs and reducing the value of a single dollar.

Imagine a simplified example. You’re in a small village with a few cows, and no one has much money, so no one is willing to spend much on a pint of milk. One day a rich person comes through town and gives every villager a hefty stack of gold coins before leaving. Flush with money, you stroll up to the one and only local dairy farmer and ask for two pints of milk.

The farmer apologizes, explaining she’s sold out for today, as she had many people show up that day to buy milk. You come back tomorrow, but again the farmer has sold out. You make the farmer an offer: If she saves you a pint of milk tomorrow, you’ll pay double the going rate.

Thus begins a spike in inflation because your fellow villagers are also willing to pay more since there’s so much more money floating around the village. Prices skyrocket, and each coin becomes worth only a fraction of its previous value because, ultimately, value comes from rarity. The more common a thing is, the less value it holds.

Too much inflation is, of course, a bad thing. Look no further than the hyperinflation Germany experienced in the 1920s, in which notes lost value so fast that wives showed up to their husband’s factories with wheelbarrows several times a day to quickly convert their pay to real goods like food. True story.

But too little inflation or deflation is also bad. It means people don’t have enough money and aren’t spending or investing it, actions that drive economic growth.

As a general rule, the Federal Reserve aims for around a 2% rate of inflation each year.

Real Estate as a Hedge Against Inflation

Real estate values and rents not only tend to keep pace with inflation, but actually drive inflation itself. As a result, they often rise faster than the official CPI inflation index.

In the third quarter of 1991, the median U.S. home price was $120,000, per the Federal Reserve. Yet home prices in the third quarter of 2021 reached a median value of $404,700 — over three times higher than 1991 despite inflation only accounting for a fraction of that rise.

Because real estate is, well, real. It’s a physical asset with intrinsic value. Regardless of the currency, people need and want it and adjust their offers to buy or rent it as needed to secure it. That makes it one of the most reliable hedges against inflation.

Rental Properties’ Protection from Inflation

Every year, the dollar loses a little value. And every year, landlords raise rents (or at least they should) to keep pace with or surpass inflation. For this reason, rental properties offer excellent protection from inflation. You buy the property with today’s dollars, borrow a fixed-interest rental property loan and then raise rents even as your mortgage payment stays the same.

Say you bought a median house 30 years ago for $120,000 and borrowed a $100,000 rental property loan at 5% interest. Your monthly payment would be $536.82. At that time, imagine the property rented for $1,400 per month. You earned a reasonable cash-on-cash return, but nothing earth-shattering. But with every year that went by, you raised the rent. Today, it rents for $3,200 per month — yet you still only pay $536.82 for the mortgage payment.

And hey, after 30 years, you’d have paid the loan off entirely, dropping it to $0.

See how inflation favors landlords and real estate investors?

Now that most eviction moratoriums have ended, consider buying your first rental property. Or your 10th, as the case may be! Alternatively, buy fractional ownership in a rental property. Check out arrived homes or co-investing programs for examples.

Land

Mark Twain famously put it like this: “Buy land, they’re not making it anymore.”

As with rental properties, land has intrinsic value. We need it for farming, for building homes on, for building commercial properties on, or simply for recreation such as fishing and hiking. And the more humans we populate the world with, the scarcer and more valuable land becomes, which makes land an excellent hedge against inflation.

Real Estate Crowdfunding Investments

You don’t have to buy real estate directly to invest in it. There are many types of real estate investments, some of which are completely passive.

With a regular brokerage account, you can buy publicly traded REITs (real estate investment trusts). By law, these funds must pay out at least 90% of their profits in dividends, making them a reliable source of passive income. But not necessarily a great source of growth, and therefore inflation protection.

Private REITs, a form of real estate crowdfunding investment, are far less regulated, making them more flexible. Some pay high dividends, others reinvest much of their revenue into new properties. Reinvesting revenue into growing their portfolio

But with that lesser regulation comes an even greater responsibility on your end to research funds before investing. I’ve invested my personal money in Fundrise and Streitwise as part of my investment strategy to build a diversified portfolio of real estate assets. So far, I’ve been happy with them, but do your own due diligence before investing.

You can also check out real estate crowdfunding investments Diversyfund and Modiv to further diversify and reduce your inflation risk. Just beware that you can’t sell most real estate crowdfunding investments on the secondary market — you’re locked in for the long term.

Property-Secured Loans

Lending money secured by real estate provides both strong returns and a hedge against inflation.

I’ve lent money in the form of private notes to several real estate investors I know personally. I’ve also lent money through crowdfunding platforms like GroundFloor. The platform lets you invest as little as $10 toward any given loan: you pick and choose the loans you like.

It makes for an easy and completely passive way to protect yourself against inflation, particularly if you invest in short-term loans like I do.

Refinance Adjustable Long-Term Loans

While not an “investment” per se, your leverage directly impacts your investment returns.

One of the ways that the Federal Reserve combats inflation is by raising interest rates. When inflation runs rampant, the Fed makes borrowing more expensive. Banks lend less, companies borrow and spend less, and individuals follow suit. But you know what higher interest rates mean for adjustable-rate loans. Expect your rates to leap upward if you have an adjustable-rate mortgage (ARM).

Interest rates are extremely low in the wake of the coronavirus pandemic, with the Fed funds rate still near 0%. If you have an ARM or adjustable rental property loan, consider refinancing it to fixed interest.

Other Investments to Protect Against Inflation

We love real estate around here, if you couldn’t tell. But that doesn’t mean it’s the only option on the table for hedging against inflation. As you review your entire investment portfolio, keep these investments in mind for diversified protection from inflation.

Growth-Oriented Stocks

When you own a stock, you own a tiny share in a company. And when inflation hits, what do companies do?

They raise prices accordingly.

Investors drive up stock prices by buying more shares of companies that do well. With more money in circulation, investors put that money to work, often by investing in fundamentally-sound companies. That makes good companies’ stocks nearly inflation-proof.

Sure, a 5% inflation rate could devalue each of your dollars over the next year. But if your stocks rise by 15%, then you still earn a “real” return of 10% from the stock market.

And no, you don’t need to pick individual stocks. Buy shares in an ETF (exchange-traded fund) or mutual fund to diversify your stock portfolio.

Don’t get hung up on the returns of real estate vs. stocks. Anyone pursuing financial independence should buy both, because they bring different strengths to the table and serve different roles in your portfolio.

Commodities

Commodities, such as precious metals, oil and natural gas, grains, beef, orange juice, and electricity, are all real assets with intrinsic value just like real estate. People still need and want them just as much during periods of inflation, so they pay the going rate.

Even when these commodity prices and gold prices skyrocket because of the effects of inflation.

As an added bonus, these real assets tend to do well during recessions. They therefore protect you not just from inflation concerns but also economic depressions.

You don’t need to go out and hoard orange juice bottles or oil tanks in your garage as an inflation hedge. Instead, just buy shares in a commodity ETF, such as the iShares S&P GSCI Commodity-Indexed Trust (GSG) or the WisdomTree Continuous Commodity Index Fund (GCC).

Treasury Inflation-Protected Securities (TIPS)

TIPS ensure you never lose money to inflation. Granted, as Treasury bonds, they won’t blow you away with their returns either. But at least they provide a guaranteed hedge against inflation.

They work like this: in addition to the standard interest these bonds pay, the face value adjusts up or down based on inflation (specifically the change in the Consumer Price Index or CPI). For example, you buy a TIPS bond for $1,000, that pays 2% in annual interest. In that first year, you earn $20 from the interest payouts.

But imagine inflation spiked by 4% that year. Ordinarily, that would mean you actually had a real loss of 2% on your money. However TIPS adjust the face value to reflect that jump in inflation.

At the end of the year, the principal of your TIPS rises from $1,000 to $1,040. So, the following year, they pay out your interest based on $1,040, not your original $1,000. So instead of paying $20 the following year, they’d pay you $20.80. When they mature, you get the face value for them (or the original amount in the unlikely event of deflation).

Note that you can buy shares in a TIPS fund ETF if you don’t feel like holding bonds directly. Don’t forget that they’re still Treasury bonds. Don’t expect to get rich off of them. But they do offer protection against inflation.

What to Avoid When Hedging Against Inflation

The investments above are all well and good, but what asset classes do you need to watch out for during inflationary periods?

First, avoid long-term bonds that lock you in for a low interest rate. If you lend money in the bond market at a fixed 2%, and inflation soars at 5%, your effective real return is -3% on your money each year. In technical terms, you’re out of luck.

The inverse is also true: you want to borrow money at fixed, low interest rates. You want to be the one borrowing at 2% when inflation jumps.

Note the emphasis on fixed low interest. As outlined above, you want to avoid adjustable rate loans when inflation comes a-knocking. Remember, the Fed raises interest rates to combat inflation!

Finally, in your stock portfolio, avoid dividend-oriented stocks in favor of growth-oriented stocks. A reliable dividend of 5% sounds great, until inflation eats up all of it. If the only real appeal of the stock is its dividend, look elsewhere. Specifically, look to stocks whose appeal lies in their upward price momentum.

Final Thoughts

Real estate makes an outstanding hedge against inflation. That goes particularly for direct real estate ownership, but also applies to indirect real estate investments like private REITs and property-secured loans.

But real estate isn’t your only option to protect from inflation. Look to growth-oriented stocks, commodities and TIPS as additional options. For those pursuing FIRE, lean more into growth-oriented stocks and leave the commodities, TIPS and bond portfolios for others.

They call inflation the “worst tax” or the “silent tax” because it saps your money without you even noticing. But it doesn’t hit everyone equally; those who know how to hedge against inflation can turn it to their advantage rather than succumb to it.

Related:

This article
originally appeared on SparkRental.com and was
syndicated by MediaFeed.org.