Is it possible to profit from inflation? For most people, inflation means losing money. It’s not overt where someone comes and forcefully takes money from their wallet. It’s more insidious with the prices of goods and services going up leaving your money with less purchasing power.
Simply put, your money just doesn’t stretch as far as it used to during inflationary times. Of course, nobody likes losing money, but inflation is out of our control. And while that’s true, some people always seem to profit from inflation. What do those people know that the rest of us don’t know?
Maybe you’ve heard that multifamily real estate can be an excellent hedge against inflation. But do you know why? Allow me to walk you through it so that you can better understand why multifamily real estate can insulate you from the negative effects of inflation. And it may even help you to profit from inflation.
But first, you have to understand the differences between how residential real estate and commercial multifamily arrive at their appraised value.
Commercial vs. Residential Appraisals
Residential real estate (1-4 units) are typically appraised using a sales comparables (comp) approach. So if you wanted to know what your house was worth, an appraiser would evaluate what has sold within a half-mile radius of your house during the previous three months.
Once that data is accumulated, they can determine a price per square foot range for the properties in your neighborhood. At that point, they’d simply multiply that number by the square footage of your house. And voila, that’s what your house is worth.
Commercial real estate (including multifamily) is appraised very differently than residential real estate. Instead of using the comp method, an income method is employed. The more income a property brings in, the more it is worth.
Here’s how it works.
The formula for commercial real estate valuation is Value = Net Operating Income / Capitalization Rate.
Net operating income (NOI) is the product of gross operating income (all rents, fees, and other income) minus operating expenses. This does not include debt service (mortgage payments) or capital expenditures.
Capitalization Rate (Cap rate) is the unleveraged return one would expect to receive from a property. So if you owned a property free and clear without any financing, the return you received on that property is your capitalization rate.
Cap rates are expressed as percentages and vary from market to market. Within each market, cap rates have a historical range as well. Typically that range is somewhat narrow.
So if a property had $500,000 in NOI and the cap rate in that market was 5%, you’d expect it to be valued around $10 million ($500,000 / 5% = $10 million).
C.A.P.T.
Another concept you should be familiar with is the number of ways an investment in apartments can pay you. We use the acronym C.A.P.T. It stands for cash flow, appreciation, principal pay down, and tax benefits.
The cash flow is the current and ongoing payments to the investor from rents. In financial terms, it is the yield component of the investment. In addition to the yield, there is also equity growth from appreciation and paying down the mortgage each month. The investor realizes this equity component of their investment upon liquidation of the investment.
I mention this because, in the following example, we’ll be evaluating both the yield and the equity growth from a hypothetical apartment investment to illustrate why apartment investments can be such a great way to prevent you from losing money to inflation.
Inflation and Multifamily Returns
Multifamily real estate has a long track record of beating inflation. Over the last 43 years, it has done so 37 times. In comparison, the S&P 500 has only beaten the inflation rate 29 of those 43 years.
How is multifamily able to provide these more stable and consistent inflation-busting returns? Let me run you through three different scenarios. One in which rent growth exceeds CPI. Another in which rent growth equals CPI. And a third in which rent growth lags behind CPI.
Our hypothetical apartment investment looks like this:
100 – unit property
$10 million valuation
$1 million in gross operating income (GOI)
$500,000 in operating expenses
$500,000 net operating income (NOI)
5% cap rate (steady)
5% inflation rate (CPI)
7% rent growth (scenario #1)
5% rent growth (scenario #2)
3% rent growth (scenario #3)
Scenario #1 – High Inflation / Higher Rent Growth
When inflation rises rents tend to rise. Since multifamily has short lease contracts (typically no longer than one year) they are nimble enough to respond to inflationary pressures and raise their rents in response.
That is a real benefit to apartment investors that is not available to other segments of the commercial real estate space. Typically office, retail, and industrial properties utilize longer-term contracts making it difficult for them to respond to inflation. So achieving higher rent growth than CPI with apartments is a plausible scenario. And this is the scenario in which you truly do profit from inflation.
In this scenario, we are assuming a 7% rent growth and a 5% inflation rate.
GOI – $1 million x 7% rent growth = $1,070,000
Expense growth – $500,000 x 5% inflation = $525,000
NOI – $1,070,000 – $525,000 = $545,000
NOI = $545,000
In this example, our NOI increased by $45,000 which means net distributable cash flow (yield) to the investors increased. Now let’s use that NOI number to see how much our equity grew.
Value = NOI / Cap rate
$545,000 / 5% = $10,900,000
Value = $10,900,000
So in this scenario, our yield increased by $45,000 (from $500K to $545K), and the value of our property increased by $900,000 (from $10M to $10.9M). We’re not losing money to inflation, we’re making money. This is obviously an ideal situation for the investor. But what happens if rent growth doesn’t exceed the rate of inflation? What if they both go up equally?
Scenario #2 High Inflation / Equally High Rent Growth
So in this scenario, both the rate of inflation and rent growth are equal at 5%. Let’s do the math.
GOI – $1 million x 5% rent growth = $1,050,000
Expense growth – $500,000 x 5% inflation = $525,000
NOI – $1,050,000 – $525,000 = $525,000
NOI = $525,000
Value = NOI / Cap rate
$525,000 / 5% = $10,500,000
Value = $10,500,000
As you can see, even when rent growth merely keeps up with inflation, the investor still wins (and profits from inflation). In this scenario. A 5% increase in income equates to a less than $42 increase in rent for each unit per month. The owner’s expenses also went up 5% from inflation, but that costs him/her less than $21 a unit.
That increase in yield is money in the pocket as well as equity growth in the valuation of the property. Nobody’s losing money in this situation.
Scenario #3 High Inflation / Lagging Rent Growth
In the above two scenarios, investors benefit from the effects of inflation. But what would happen if rent growth couldn’t keep up with inflation? Will inflation win? Will we be stuck losing money?
Let’s redo the math for the same rate of inflation of 5%, but this time rent growth lags behind at only 3%.
GOI – $1 million x 3% rent growth = $1,030,000
Expense growth – $500,000 x 5% inflation = $525,000
NOI – $1,030,000 – $525,000 = $505,000
NOI = $505,000
Value = NOI / Cap rate
$505,000 / 5% = $10,100,000
Value = $10,100,000
How is it possible to achieve both higher yield ($5K) and increased equity ($100K) when inflation outpaces rent growth? It’s simple, B-grade commercial multifamily real estate has expenses that are around half of the income it generates.
So in the case above, the inflation rate was applied to $500,000, while rent growth was applied to the higher income of $1 million. So even in the downside scenario, this fact buffers apartment investments from the deleterious effects of inflation.
What other investments can do such a good job of insulating the investor from losing money to inflation? Will they need this downside protection? It’s not likely given that CPI has only outpaced real estate six out of the last forty-three years. And even in a year like that, inflation would have to be significantly higher than rent growth for the investor to actually lose money to inflation. So even if you don’t profit from inflation, in many instances, you’d be protected.
Would You Rather Profit From Inflation Or Be Victimized By It?
If you’re trying to accumulate wealth for retirement, then losing money to inflation isn’t part of your plan. There are some people who know how to profit from inflation. They invest in assets that fight against inflation.
Apartment investments can be a great hedge against inflation. And now that inflation has arrived, more and more investors see multifamily real estate as an essential component of their portfolio.
They know that the S&P 500 doesn’t have the same track record for beating inflation that multifamily real estate does. They also enjoy the added benefits of true diversification and lower volatility that comes with investing in apartments.
Ultimately, if you’re looking for consistent returns from an investment that can keep you from losing money to inflation, then it might be time to add multifamily real estate to your asset allocation.
Unfortunately, inflation is here. Will you be losing money to inflation or will you profit from inflation? The choice is yours.
