Sticky Inflation Fears
Since April 2021, the CPI annual inflation rate has been above 3% every month. This has caused some to worry that inflation is here to stay. Mark Carney, former Bank of Canada and Bank of England governor remarked earlier this year: “the long era of low inflation, suppressed volatility and easy financial conditions is ending.” Morningstar’s U.S. Head of Economics noted in similar fashion: “Consensus has largely given up on the idea that inflation will be transitory, [though we] think most of the sources of today’s high inflation will abate…over the next few years.” These fears have induced Jerome Powell’s recent vow, quoting a phrase from Paul Volcker that the Fed will use its policy tools to “break the grip of inflationary expectations.”
During inflationary times, real estate is a great asset class to invest in
Academics and financial markets professionals advocate several different strategies to combat inflation. In a working paper by Brad Case (NAREIT SVP) and Professor Susan Wachter of The Wharton School at UPenn, the scholars identified several inflation protection assets, in descending order of protection: commodities, real estate, stocks, TIPS, and gold. This being said, the authors caution that commodities have the worst performance amongst asset categories during periods of low inflation, and that asset managers should invest in real estate to avoid significant unidirectional risk in the bust cycle in commodities.
Real Estate income (NOI) has outperformed inflation (CPI) over the past two and a half decades
1995-2021, year-over-year growth; NOI and CPI indexed to 100 in Dec. 1995
Source: Green Street Advisors, Bureau of Labor Statistics; Note: Data as of December 31, 2021. Real estate Net Operating Income growth is the average year-over-year growth across the apartment, industrial, mail, office, and strip retail sectors. Inflation is represented by the Consumer Price Index (CPI).
Blackstone’s Joe Zidle and Nadeem Meghji note that investors should be selective in real estate, and that residential and industrial investments are primed to perform in the current inflationary period.
Real Estate Performance in Different Inflationary Regimes
1978-2Q22, quarterly, headline CPI, NCREIF ODCE Index, year-over-year %
Source: JP Morgan Asset Management
Shifting investments to real estate during inflationary periods is no secret. With investors moving money into tangible assets and bidding up prices, it is important to find an investment niche that can maintain healthy risk-adjusted returns. JP Morgan’s asset management group points to exploring nontraditional and non-core real assets as areas for opportunistic investing. Additionally, Blackstone suggests prioritizing assets with shorter lease duration and strong growth fundamentals “provide the opportunity to regularly reset rents to prevailing market rates in an inflationary environment,” including hotels, the cousin of short-term rentals.
This line of thought is simply stated by Brad Case and Professor Susan Wachter in their working paper: “The property types expected to provide the strongest inflation protection are the ones characterized by short-duration leases, or by rents linked to revenues.”
What are the implications of inflation on short-term rental investments?
Short-term inflation, debt implications and strategies
It is common to add mortgage financing to STR investments to enable a larger portfolio, diversify risks, and increase cash flow and returns of well-selected properties. Different strategies for financing emerge depending on whether you think inflation is a short- or long-term phenomenon.
If you think inflation duration is short-term in nature and that we are already at peak inflation, we suggest initially buying properties in cash, watching closely how the Fed sets interest rates and then taking out a mortgage loan later. Paying all cash initially to get to a better refinance period will not significantly alter the IRR, and there is opportunity to find great deals on investment properties during times when other investors are on the sidelines.
This being said, periods of expected high short-term inflation, high interest rates, and high property prices are a time to be cautious when making investment decisions. This is a great time to focus on educating yourself on the market.
Long-term inflation, debt implications and strategies
When inflation is viewed as a long-term trend, investors should consider getting a loan soon, to allow rent and property price inflation to erode the debt burden over time. Remember that long-term inflation is actually your friend for debt – a September 2022 Morningstar article advised: if investors “think high inflation will persist, some investors may consider borrowing money to invest in real estate, which allows them to repay the debt with inflated dollars.”
Locking in a loan during a season of relatively stable mortgage rates amidst high inflation is ideal. And when rates fall, as many economists forecast, the option to refinance to lower interest rates becomes available.
An STR investor will typically have the best opportunity to afford interest and loan payments versus competition from long-term rent or primary residence owners (assuming favorable STR demand, favorable regulation, etc.). Additionally, most STR investors have the free option to convert to a “medium” (e.g., 1 month minimum stay) or long-term rental if the economics are better.
Investors who acquire a loan during a period of inflation should be ready to forecast and work through seasonality, saving earnings from peak season to meet debt obligations in the low season if cash flows are not enough to cover them. This is an area where good property managers can provide significant assistance in forecasting or warning about upcoming periods of low cash flows above debt service costs.
Other strategies
There are significant other strategies to consider during a time of inflation. Sophisticated STR property managers know that there are certain ways to spend resources efficiently to increase property revenue and reduce costs. Cutting edge data analytics and machine learning allows for investors to continuously and dynamically improve the pricing and occupancy of their properties.
Additionally, there are opportunities to review labor and costs to run properties. Investing in technology to manage homes early in an inflationary period can help save on technology costs and help identify opportunities to cut back on costs that would otherwise grow rapidly during the period of inflation.
