How Does Inflation Impact Real Estate Investing

How Does Inflation Impact Real Estate Investing?

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?

Up-Front CapEx

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.

Conclusion

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?

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13 Comments

  • Mario Reply

    Hi Ben, your speaking of a 5 unit plus, right. I have a similar situation but in a 4 unit, lady has been there for 35 years plus. Again a little different from your situation.

    • Ben Reply

      No, Mario – this works the same way in small multi as well. True, the buyer is simpler and won’t capitalize value as much in the small space, but you are leaving CF on the table…it is what it is. So, decide if the headache of getting it is worth the effort 🙂

  • Steve Anderson Reply

    I just bought a building (15 unit) where some of the rents are also below market (identical to what you are describing). The building was owned by an elderly couple who recently experienced health issues and when no one else in the family wanted to deal with it, I was lucky enough to be the 1st one they called. This exact discussion took place with my banker ( some tenants have been in the building 10+ years) and it is fully occupied. My plan is to bump everyone $25/mo at lease renewals, and if they vacate, I will push for current retail rents. I always enjoy reading your posts/blogs as i’m from the midwest/great lakes region as well and can relate to your analogies.

    • Ben Reply

      Yep – bankers are not paid to be creative…they are paid to be conservative. It’s always fun to discuss these deals with them. But, there are good ones!

      Thanks so much for leaving a comment, Steve!

  • Gareth Reply

    I’m an Aussie investor and I face the same problem here too. I use the suburb vacancy rate, which is a statistic that’s easy to get a hold of here to determine the risk if the tenant decides to vacate. I’ve had pretty good success where the vacancy rate is <2% (ie the demand is high and the market's has the ability to pay)

    • Ben Reply

      2% is great, Garth. I am not able to do much under 5% 🙁

  • Dave @ www.AffordEverything.com Reply

    I find that raising rents accordingly helps the income created from my investments, keep up with inflation. I have a 3 bedroom, that I purchased about 7 years ago, i rented it out for $500 then, today its worth atleast $1000 in rental income

    • Ben Reply

      Absolutely! But, we are subject to market forces in this…

  • Nick Raineri Reply

    Inflation is something that will always continue to be around and like you said it is part of what protects the real estate business. The example you have provided is interesting. It’s tough deciding what action to take, whether to raise the rent or keep the long term tenant happy and avoid the headache. Thanks for sharing Ben.

    • Ben Reply

      Thanks for reading, Nick!

  • Dave Reply

    Finally someone gets it! Getting market rent is ideal with a good tenant, but if you factor in all the costs of turnover, your often times better off with slightly below market rent, while having to invest no extra money and be vacant for a couple months. I have a third floor tenant in a home for the last 30 years. To turn her apartment it would need 6-7k in renovations, plus a roof 10k. I could increase rent $150 per month, but at that point think how many years I’d need to make my money back??? I went with a $25 bump up and she was happy to stay, with $0 out of pocket.

    • Ben Reply

      Bam!

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