Inflation can destroy the value of an asset that doesn’t increase as inflation increases. This is especially true in depreciating assets such as cars, bicycles, and boats. The asset needs to have some underlying feature that allows it to increase when inflation increases. When that happens, the asset acts like a hedge, offsetting the value-decreasing effects of inflation.
We’ll explore if real estate offers that type of hedge against inflation.
Inflation Primer
Let’s do a quick primer on what inflation is. Inflation is measured using a basket of goods. As the price of these goods increases, the consumers’ purchasing power decreases.
To see how this works, we’ll take a basket of goods (also called CPI) that cost $100 at the beginning of the year. During that year, inflation increased by 6%. At the end of the year, the basket of goods would have risen to $106.
The U.S. Federal Reserve has the mandate to maintain stable prices. It does this through monetary policy (as opposed to fiscal policy, which the federal government does).
When inflation increases above a level set by the FED, creating price instability, the Federal Reserve raises interest rates, which is one of its policy tools. This slows down the economy and decreases demand. With slowing demand, prices begin coming back down.
Particularly for real estate, as the cost of materials and labor increases, the overall cost to construct a building will also increase. This causes the price of real estate to go up. This is the underlying feature alluded to in the introduction. Rents also go up since the cost to maintain a building increases.
As a side note, inflation took off once the U.S. removed its dollar peg to gold (called the gold standard). When this happened, the dollar was no longer backed by gold and became a fiat currency. You can see the effects of inflation on this popular Campbell Tomato Soup chart.
To find out if real estate is an inflation hedge, we’ll first answer the question — what is a hedge?
What Is a Hedge?
A hedge is meant to offset a decrease in an asset. Hedging is less complex with a stock portfolio. An investor who buys 100 shares of stock might also buy one put option in the same stock, thus hedging against downside risk. If the stock shares drop, the put’s value will increase. The net result is less of a decrease in the value of the portfolio.
Real estate doesn’t really have an equivalent to that scenario. But it does have loans, and loans have interest rates. Interest rates change over time. An investor with a high rate loan may seek to refinance into a lower rate loan. This is one example of hedging.
To see how this works, let’s say an investor needs a loan to acquire a property. However, interest rates have recently increased, increasing the loan cost. New debt is more expensive than existing debt.
The investor with existing debt (at a lower interest rate) is earning better returns than those with new debt. The gain should be equal to the spread of the two interest rates. Investors with a higher rate loan will wait for rates to come down at some point and lock in a lower rate as a hedge against higher rates further in the future.
The above is an example of hedges in real estate. This is different from real estate as an inflation hedge, which is the topic of the next section.
Real Estate Performance Vs. Inflation
If real estate is an inflation hedge, the price of real estate should increase as inflation increases. As real estate prices increase with inflation, the value of real estate is maintained. The correlation between the increase in inflation and real estate determines how much value real estate can maintain.
For example, inflation rises by 3.00% in a year, but real estate only rises by 2.50%. In this scenario, inflation is increasing 17% faster than real estate. After one year, real estate will not maintain 100% of its value.
At 3.00% inflation, a property with a value of $500,000 at the beginning of the year will increase to $512,500. However, inflation is increasing quicker ($515,000). While the property is gaining value, it is losing to inflation ($2,500/yr in this case).
But that is better than an asset that did not increase at all. If the same $500,000 was invested in an asset that did not increase with inflation, it would have lost $15,000 instead of $2,500.
Historically, how has real estate performed against inflation? We can categorize this into two classes of real estate — REITs and real property.
From Nareit1, they compare REITs to the S&P 500 from different periods of inflation. You can see from this chart that as inflation rises, REITs perform better than the S&P 500. In this case, we can say that REITs are an inflation hedge.
Keepingcurrentmatters.com directly compares inflation to home prices. Except for the 1980s and 2000s, home prices were higher than inflation. Even during those two periods, home prices were just below inflation. This shows that home prices are a hedge against inflation.
What about during the time inflation ravaged the 1970s? The above chart shows that home prices were a hedge against inflation during that period. But let’s zoom in to see what happened to home prices during that decade.
Looking at the two charts below from FRED2, chart 1 shows inflation. There was a dip in 1972 then inflation took off following the removal of the gold standard.
Inflation accelerated from 1972 into 1974. Home prices began their ascent in 1971 and didn’t pause until 1979, as shown in chart 2. Inflation peaked in 1980. That’s when home prices began their ascent once again. And you can see where they went from there.
Even with such high inflation during the 1970s and into 1980, home prices rose throughout the entire decade, taking only a brief pause in 1979.
Graph 1
Graph 2
The verdict? Yes - real estate is an inflation hedge. While inflation did race above the rate of increase in home prices during the 1970s, these were temporary periods as inflation also dropped drastically in 1972 and 1976.
While real estate won’t track inflation 1:1, it does hold its overall value during a period when inflation is increasing.
1 Nareit is a Washington, D.C.-based association representing a large and diverse industry that includes equity real estate investment trusts, mortgage REITs, REITs traded on major stock exchanges, public non-listed REITs, and private REITs
2 Federal Reserve Economic Data, FRED is an online database consisting of hundreds of thousands of economic data time series from scores of national, international, public, and private sources.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
Past performance is no guarantee of future returns. Investing involves risks, including the loss of principal. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure.
Examples shown are hypothetical and for illustrative purposes only.
All investments have an inherent level of risk. The value of your investment will fluctuate with the value of the underlying investments. You could receive back less than you initially invested and there is no guarantee that you will receive any income.
