One of the reasons rentals are such an amazing investment vehicle is because they are inflation-protected. Here’s how the thinking goes:
Monetary Inflation’s Impact to Investment Properties
In our economy, certain amount of currency chases certain amount of products and services. The amount of currency can increase, without causing damage to the economy, only if the amount of products and services it chases also increases in tandem, in which case monetary supply and that which money pays for are in balance.
In a debt economy, specifically a fractional reserve banking dept economy, expansion of monetary supply is institutionalized into the economy. The FED’s stated goal is 2% annual inflation…
How Does Price Inflation Work?
If the monetary supply is increasing according to the FED’s goal by 2%/year, then the existing pool of money chasing the same pool of products and services devalues by 2%. There is 2% more money in the pool which is meant to buy the same amount as before.
In order to achieve equilibrium, the amount of goods and services that the newly increased monetary supply is to pay for needs to grow by 2% as well. If that doesn’t happen, then price of all items will increase by 2% to accommodate expansion of monetary supply.
This is a very basic view, but there it is…
Investment Property Rent Inflation
One of the goods and services in the pool is the rent we can charge our tenants, and certainly, while looking at today’s rental market it is difficult not to acknowledge a huge amount of price inflation in rents. So, the question is – is the demand there to support this inflation?
The sustainability of pricing is a function of 2 things – people’s ability to pay, and demand. The demand is driven, on the most basic level, favorable population trends. Growing number of people wanting apartment units result in strong demand.
And people’s ability to pay is all about labor markets. Even the nicest people won’t pay you if they don’t have the money…
Having said this, certainly there are places around the country which easily justify the rent inflation we’ve had. However, looking at the Mid-West, this becomes a much more clouded conversation. But even still, my experience has been that price inflation in rents is alive and well in Ohio!
My Tri-plex as an Inflation Case Study
When I bought this building about 5 years ago (this is one of the case-studies in CFFU), the apartments were renting for $525 – $550. Recently, I rented one of the units for $700 – if that’s not price inflation, I don’t know what is…
One of the units, however, has been rented by a retiree since before I owned the building. She pays her rent like clock-work, and unless there is a serious issue, she doesn’t bother me with anything.
Sounds great, right? Yes – she is great! But, in a market which support $700/month rent, she is paying $500, and therein lies a problem…
I Am Losing Cash Flow and Value
Obviously, I am leaving some cash flow on the table, which is an issue. But, perhaps even more important is the fact that I am leaving equity on the table as well. A potential $200/month going straight to my NOI (not really, but more about this later), means that I am losing $24,000 of equity at 10 Cap:
$200 x 12 = $2,400/annum of additional NOI
Value = NOI / Cap Rate
Value = $2,400 / 10% = $24,000
This means that by increasing her rent by $200, I can potentially create $2,400 of cash flow, and improve the value of my building by $24,000. So – why haven’t I done it?
In order to rent this unit for $700, it would need about $5,000 of CapEx. But, in and of itself, the capitalization on this expense is totally worth it. Having spent $5,000 to upgrade the unit, if I were to gain $2,400/year of additional NOI (and CF), I’d be recapitalizing at the rate of 48%:
$2,400 / $5,000 = 48%
But, this is not the entire story!
Economic Losses and Vacancy
First of all, if I did this, the apartment would in all likelihood be vacant for a couple of months. This in and of itself would cost me $1,400. So, in year 1, I’d have to plan on deducting this from the presumed additional income of $2,400.
Additionally, when I do re-rent the unit, I’ll be trading a known commodity in the tenant who pays on time, for an unknown commodity. There is a risk associated with that, and some amount of economic loss must be assumed. In other words, I am much less likely to have to evict the current tenant, and encounter downtime and additional rehab costs, than a new tenant.
Not only that, but at a higher price point I’ll be attracting a different type of a tenant – likely someone much more picky about every little thing, and considering this is a 1968 building, there are a lot of little things to pick at. So – the R&M budget has to go up!
So – Do I Hike the Rent?
Well, if she informed me that she is moving out, the answer would be a simple yes. If the unit is going to be vacant anyhow, and in need of a turn, might as well spend a few more bucks on the upgrades and get the higher revenue.
However, such as it is, the answer is not nearly as simple. I’ll likely have to do it soon, whether I like it or not. Not so much because of the cash flow, though there’d obviously be a bump, but more because I can’t afford to leave $20,000+ of value on the table. This is equity that I can leverage into additional acquisitions. Nothing trades today for 10 Cap – not even in Ohio. Even if the actual bump to the NOI ended up being $1,500/annum instead of $2,400, this still constitutes a nice chunk of leveragable equity.
As I mentioned in the beginning, one of the main reasons we buy real estate is because it is an inflation-protected security. If we are able to hike rents, we are by definition able to protect ourselves from the erosion of buying power of our dollars due to inflation.
That said – I am afraid I’ll have to hike her rent sooner rather than later.
What do you think, guys?