Shouldn’t Real Estate Do Well During Inflationary Periods?

Shouldn’t Real Estate Do Well During Inflationary Periods?

Inflation has the attention of the financial markets, and the Federal Reserve just raised interest rates by 25 basis points because of it. Headline CPI was 3.4% at the last reading, well above the Fed’s stated goal of 2.0%. Stripping out food and energy, core CPI was 2.4%, the lowest level since March 2021.

But food and energy costs are a big reason why affordability remains a hot political issue. Our renters are paying $4.44 per gallon for regular gasoline, according to AAA. They see grocery staples like ground beef almost double what it was in 2017. Wages have risen 3.1% annually, which sounds fine until you compare it to 3.4% headline inflation. Real wages are going backward, and our renters feel it.

At the same time, corporate profits are surging. According to the St. Louis Fed, after-tax corporate profits surged 8.9% quarter-over-quarter in Q2, a 28.2% increase year-over-year. Those gains don’t appear to be showing up paychecks. Corporate profits are booming because the American consumer, at least the higher-earning one, remains willing to spend. Economists call this a K-shaped economy, one where the top earners are pulling ahead and everyone else is falling behind.

It certainly looks that way at our properties. In apartments where renters are more affluent, rents are growing, delinquency is minimal, and units are full. The opposite is true at any workforce housing property. Rents are flat or down, delinquency is high, and occupancy is always at an uncomfortable spot.

With inflation back in the conversation, I’ve been asking myself: shouldn’t inflation help real estate? Given the split we’re seeing, I don’t think there’s a straight answer.

In a vacuum, inflation is good for real estate and many other kinds of assets. Because the value of cash falls as inflation rises, you want to own assets that have a chance to appreciate. On the other hand, interest rates typically rise during inflationary periods, as we saw this week. That’s usually bad for real estate: higher interest rates lead to higher cap rates and thus lower values. The counter argument is that the same inflation pushing rates up usually pushes rents up too. Expenses rise as well, but if rents grow faster, net operating income can grow enough to offset the higher cap rate. That leaves real estate in a better position than cash.

That’s roughly what happened in 2021. When inflation took off, so did rents, just about everywhere. Expenses were slow to catch up, and the Fed didn’t start increasing rates until March 2022, well after inflation was running hot. If you owned property during that window, NOI grew fast. We were able to capitalize on this phenomenon and sell a property in Austin in late 2022. Rates were already climbing, but buyers were still underwriting off the rent growth of the prior 18 months and cap rates hadn’t fully caught up yet.

There’s a big difference today. The inflation reaching rents isn’t here now. Core CPI at 2.4% shows inflation isn’t widespread. It seems tethered to the war in Iran and energy prices. And while the American consumer appears to be doing fine overall, with low rent-t0-income ratios, that isn’t the case for our renter.

Workforce housing properties are going to feel the squeeze. Those renters are losing ground in real terms. Energy is a big part of their budget, and so are utility reimbursements. We’ve seen utility costs, particularly water and gas, rise well beyond a standard 3-5% increase. We pass that on to renters because we have to. It isn’t technically rent, but it’s part of their budget. Even if rent is flat, they’re keeping less of their paycheck because of everything else.

This limits how much rent can grow in the near term. If rents aren’t growing and expenses are, NOI falls behind. Add higher cap rates from higher interest rates, and values drop. Meanwhile, short-term Treasuries are yielding 4-4.75%, risk free. If your workforce deal has a cash-on-cash yield projected around 6.0% with flat rents and rising expenses, the Treasury is a better trade. That’s why apartments aren’t the best investment today if your business plan relies on a passive rent growth thesis.

That doesn’t mean multifamily is a bad place to be. It remains a good place to be during inflationary periods, but only if you’re not counting on the market to do all the work. I’ve been saying that niche strategies are winners today, meaning targeting a specific vintage, micro market, or leveraging a new law or regulation. Rents are growing in some markets, and those rent increases can be dependable if the fundamentals are there. They work in this environment because they create controllable NOI growth, and a new inflationary cycle only reinforces that.

Because inflation seems so tied to Iran, it wouldn’t surprise me to see rates come down once that conflict ends. Lower gas prices would ease inflation and give the Fed room to cut. Longer-term rates, which drive cap rates and loan proceeds, don’t always follow the Fed quickly, but they should drift lower if inflation expectations cool. That would open the door to rent increases (assuming supply and demand is balanced in that market), larger loan proceeds, and higher values. But real estate investors don’t typically like to bet on the direction of interest rates. It’s out of their control, and thanks to leverage, the outcome can be dire if they’re wrong. So values suffer until there’s a glimmer of hope.

That’s the case for niche strategies right now. If you can find deals in submarkets with good fundamentals today, with growing rents, and cap rates that make sense, lower rates will only make your investment better. You just won’t have relied on them.