Investing in an Inflationary Environment

How Real Estate Investors Win

The latest CPI (Consumer Price Index) readings were released today and it’s fair to say that Mr. T has the best summary: Pain. The CPI grew at a 7.5% annualized rate, the highest growth rate in 40 years. So, how should you be thinking about inflation as an investor? CPI measures a basket of everyday consumer goods, so when the CPI index rises, your buying power decreases. That is, unless you invest your hard-earned dollars into something that provides a cash yield and/or appreciation to counteract the inflation.

Real estate is known as the best hedge against inflation because it has the potential to accomplish both strong cash yields and price appreciation. Let’s dig deeper:

Cash Flow and Appreciation

When you buy a property you acquire the future cash flows that property generates. The cash flows are a function of demand for the product and market lease rates. Owning property in high-demand locations ensures plenty of demand, which usually translates into higher rents over time. Cash flows are not the only protection from inflation – you could also benefit from appreciation as future buyers may pay a higher price than you originally paid for the increased cash flows. Another reason you might benefit from appreciation is because of inflationary pressures pushing up the replacement cost.

Replacement Cost

An important concept to understand in real estate is the idea of replacement cost. Replacement cost is the amount it takes to replicate an already-existing building. 

Example: If you develop a building in 2012 for $10 million, that same building could conceivably cost you $20 million to replicate in 2022 due to increases in land value, construction costs, labor costs, etc. That’s critically important because the developer who wants to compete with your 2012 building must factor in these costs to determine whether the project is feasible. If the developer determines it is feasible, it’s probably because your 2012 building cash flows at – or close to – a level that justifies a $20 million basis. If not, then your building benefits from tougher barriers to entry and more limited supply. Either way it’s a win.

The Bottom Line on Inflation and Real Estate

The inflation conversation is actually quite simple: You can hide your savings under the mattress or opt into a low-yield savings account, but inflation can cause you to incur a negative real return. Instead, by investing in assets like real estate, your investment returns could and should be able to comfortably outpace inflation over the long-term, generating positive real gains for you and your loved ones to enjoy.