Inflation rose at its fastest rate since 1982 last year. As measured by the Consumer Price Index (CPI), inflation soared 6.8 percent in the most recent year, well above the expectations of top U.S. economists. Practically everything people buy or use has seen a major price spike. Multifamily apartment investing is gaining popularity as a hedge against inflation and economic uncertainty.
Certainly, all forms of investment can feel the effects of rapidly rising inflation. Inflation affects commercial real estate, such as apartment buildings. But those who own many dwelling units can cushion the blow of inflation on their investors.
Three Major Forms of Inflation
Consumers are well aware that rising inflation reduces their purchasing power. Here are the most common types of inflation and what causes them:
- Cost-Push Inflation. Companies in this sort of inflation pass on price increases to customers as they face increased costs. Also, a rise in the price of commodities like gasoline, steel, and lumber could be to blame for these price hikes for businesses. The rising cost of labor could be another factor in them. When commercial real estate is scarce, businesses may be forced to pay higher rents, resulting in cost-push inflation in the real estate market.
- Demand Inflation. In this case of inflation, prices rise because production cannot keep up with demand. An increase in demand for a good or service typically begins when buyers have enough disposable income to justify paying a higher price (and do so).
The Fed raises interest rates in response to rising inflation. The cost of debt consequently rises as interest rates rise.
- Inflation Due to Government Money Printing. To boost the economy and increase the number of potential jobs, the federal government may decide to print more money. By taking on more debt, the government may print and circulate more money. They might also let banks lend more money against security.
As more currency enters circulation, however, the purchasing power of any one bill gradually declines. More money in circulation does not increase consumer purchasing power but causes prices to rise.
Even though economists agree that inflation, in small doses, can be beneficial, they warn that rapid inflation can be harmful. It is especially the case when pay growth is lower than overall economic growth. Since it is unusual for expenses, prices, and salaries to all rise or fall at the same time and the same rate, an imbalance in this area can cause significant turmoil in the economy.
The Impact of Inflation on Multifamily Real Estate
Inflation has averaged between 2% and 3% annually over the past few years. The start of the Great Recession in 2008 helped the multifamily apartment market by allowing investors in such properties to receive very cheap debt.
As the world prepared for and then experienced the devastating effects of the Covington Nineteen pandemic, the Federal Reserve Bank lowered interest rates even further to bolster the economy. The economy did not suffer the same decline as it did between 2008 and 2010.
Inflation is rising rapidly, despite the relatively steady state of the economy. The current inflation rate will significantly impact the multifamily real estate investment market. These high inflation rates are predicted to have the following effects on the multifamily real estate investment market:
- Costs Of Building Are on The Rise. There is usually an uptick in building expenses during periods of cost-push inflation. As a result, this effect increases total building costs. If there is also a scarcity of skilled employees, it will take longer and cost more for contractors to assemble the requisite work crews, driving up the construction price.
According to the National Association of Home Builders (NAHB), the cost of building supplies increased by 26.1% between June 2020 and June 2021. With this proportion, the NAHB study sets a new benchmark. Before that, in 2017, the rate had reached a record high of 6.1%.
There was a severe shortage of construction workers in the same period in 2020-2021. A little-known fact is that 740,000 more workers will be required each year. If this many are hired, then the market can function normally.
- Multifamily Apartment Stock Decreases. There are markets where the rents that multifamily apartment developers can charge are insufficient to cover the costs of building a new complex. As a result, fewer apartments will be created, and the current supply will shrink even further.
However, apartment buildings were among the best performing real estate investments during the Covid pandemic’s peak. As inflationary economic conditions prevail and rise, this strong performance has persisted into the present day. It is estimated that between 450,000 and 500,000 new apartment buildings and complexes will need to be built annually to accommodate the rising number of households in today’s society.
- Price Increase. In general, the costs of apartment buildings for multiple families go up when inflation rates rise. Any building or complex, new or old, will see a price hike due to this. New property developers must increase their asking rates to cover the ever-increasing construction costs.
Conversely, as the number of available apartment complexes shrinks, the market value of those that already exist price increases. After then, investors get even more aggressive, driving up the cost of apartment buildings with several units.
- Cost of Debt Keeps Rising. During the past few years, investors in multifamily real estate have benefited from access to low-cost, fixed-rate debt in the range of 3.0 to 3.85%. Due to the accessibility of cheap financing, more investors were able to purchase multifamily dwellings. In turn, this caused these apartment complexes’ prices to rise.
Additionally, it allowed for the cheaper financing of necessary modifications to these properties, which increased the value of this asset class.
The interest rate on debt can rise dramatically during an inflationary time. The cost of purchasing multifamily apartment buildings or enhancing existing structures will increase even if interest rates rise only slightly.
- Investors are Pulling Back. Some investors will pull back due to the rising prices of multifamily apartment assets. Investors who want to stay in the market may benefit from this, as more properties may be accessible to them. However, the market for such homes may become less active due to this retreat.
But the multifamily building market has long-lasting, robust fundamentals that will inspire other investors to keep buying and developing their portfolios.
The Effectiveness of Multifamily Buildings as a Hedge Against Inflation
Apartment complexes that are privately owned have consistently outperformed other types of commercial real estate when performance is measured over time. Throughout periods of high inflation, this property type consistently outperformed the national average by more than five percentage points.
Compared to the stock market and U.S. equity apartment REITs, privately owned multifamily real estate assets have been shown to perform significantly better. Meanwhile, financial returns from the stock market and real estate investment trusts were dismal.
The analysis also showed that a 1% rise in inflation during the GFC corresponds to a 1.2% rise in private CRE excess returns. However, within the same period, a drop in the financial returns of stocks and REITS is indicated by a one percent increase in inflation. The average risk-adjusted return on private U.S. apartment complexes is also significantly higher than other asset classes.
Multifamily apartment Properties are an Inflation Hedge for Their Owners
Owners of multifamily apartment buildings can protect themselves from rising prices in several ways.
- Rent Increases. Increasing the annual rentals of apartments by the annual inflation rate is a good way for owners of multifamily buildings to protect themselves financially from inflation. If the leases are renewed annually, there might be a high turnover rate of tenants in apartment buildings. Landlords have the right to raise the rent by at least the inflation rate each year for all new renters.
- They are aligning New Lease Rental Rate Increases with CPI Growth. Apartment complex owners may restructure their lease agreements to reflect the Consumer Price Index (CPI) changes. These new lease agreements should clarify that annual rent increases will be at least as much as the Consumer Price Index (CPI) increase.
Since the CPI is the most widely used indicator of inflation, it can use to rationalize any significant future rent hikes, if necessary.
- New Vendor Contract Negotiations. Landlords of multiple dwellings can lock in rates for one to three years and even longer by renegotiating current contracts with vendors. They can implement any necessary upgrades in the foreseeable future at a reduced price during this window. Investors in real estate can also use this to protect themselves against rising costs.
Final Thoughts
The current phase of rising inflation provides excellent financial rewards for investors in multifamily apartment units. The interest rate is slowly rising, although it is still historically low. Investors in multifamily dwellings who can lock in long-term, fixed-rate financing at today’s low-interest rates will be in a strong position to profit from the present REI market.
Apartment complexes were a smart bet for investors during the pandemic’s peak. Even as the economy strengthens and inflation rises, these buildings continue to perform admirably. Investors in real estate who want to protect their holdings from rising prices should consider expanding their holdings to include multifamily apartment buildings.
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