Pricing Pressures Raise Inflation Concerns

Mitch Siegler

It’s been quite some time since investors had to consider how inflation might affect their portfolios. Today, however, inflation is again becoming something of an investment consideration.

The good news for real estate investors is that traditionally the asset class has proven to be a great hedge against inflation and should continue to be in the future. Experienced investors, though, will still take steps to safeguard their assets and position themselves to capitalize on the shifts that could emerge.

It’s not without reason that market watchers have suddenly become aware of inflation. The Consumer Price Index, for instance, rose by 2.6 percent over the trailing 12-month period ending in March, according to the latest CPI report, issued by the U.S. Department of Labor. Within real estate, the median price for existing homes jumped by 16.2 percent, year-over-year in February, according to Marcus & Millichap, while new home prices grew by 5.5 percent over the same period.

This pricing surge occurred even as 30-year mortgage rates continued their advancement during the first quarter of 2021. Developers, meanwhile, are well aware that lumber prices over the past 12 months have surged by nearly 250 percent as of April 2021, which the NAHB estimates has equated to a roughly $24,000 increase in the average price of a new single-family home over the same time period.

The big risk, however, is the prospect that rising inflation could force the Federal Reserve to begin hiking interest rates. The Federal Open Market Committee, in March, held steady, keeping interest rates near zero. And while Fed Chair Jerome Powell acknowledged there will be “upward pressures on prices,” he sought to reaffirm the markets that he believes it will likely translate into a “transient” effect on inflation.

Still, it’s against this suddenly less-certain inflationary backdrop that investors should consider a course of action in the event pricing pressures endure. The good news, at least for investors in real estate, is that the asset class is indeed an inflation hedge, a point most practitioners would have learned in their undergraduate macroeconomics classes. This is especially the case for apartments and multifamily properties financed with long-term, fixed-rate debt as leases reset every six to 12 months. This means income can keep pace with inflation and the largest expense—debt service—remains fixed.

Managing risk, finding opportunity

From the perspective of fund managers, though, inflationary periods can provide both risks and opportunities. Experienced investors, in turn, will be both proactive and cautious.

Fix it

While most have already locked in low rates when possible, the rising pricing trends should motivate borrowers to select a loan that locks in a lower rate for at least the next few years—or longer for investments with an extended time horizon. It’s not necessarily about trying to time an absolute bottom—and there is a chance borrowers may have to pay a little more to sleep better at night—but it’s all about perspective. And, if the loan is assumable by the next buyer, that can create tremendous flexibility for both best- and worst-case scenarios.

Hedge it

Based on historical values, there’s a bear argument that equity markets could be vulnerable at current prices so it’s worthwhile to maintain some balance in the portfolio. Certain investments could suffer in a rising rate environment. Countercyclical holdings, especially assets that produce solid cash flow along the way, can provide a ballast amid volatility. Another benefit for real estate investors is that the underlying assets provide solid collateral, which is generally not available from a government bond or high yield debt.

Watch it

The conventional wisdom is that rising interest rates always correlate precisely with higher cap rates. However, during the most recent periods of sustained interest rate hikes, in the mid-1990s and mid-2000s, the growth rate of the NCREIF Property Index experienced jumped well above the average growth rate. This is because rates don’t rise in a vacuum. Generally, increasing interest rates are associated with an improving economy, translating into more jobs, wage growth and higher consumer spending, which generally benefits multifamily investors, but should drive demand for commercial space as well, allowing landlords to boost rents in both cases.

Preserve it

Said another way, keep some powder dry. Experienced investors know that when things look rosy, and other investors are wildly bullish, sometimes the other side of the trade might be more comfortable. Moderation during inflection points is critical. Sell some winners; remain mindful of risks; maintain leverage ratios that provide a cushion; and preserve cash. Should inflationary pressures trigger an uptick in rates, the shift could create a lack of liquidity and selling pressure, which would also yield opportunities to capitalize upon.

To be sure, investors in multifamily properties already have plenty of variables to consider. And challenges will continue to revolve around geography (as secondary markets benefit amid the flee from gateway cities); property class (as workforce and Class-B housing are expected to outperform Class A and C assets); and resident types (as properties that cater to “renters by necessity” should see steady demand).

Moreover, strong asset management will play a bigger role going forward, as the financial strength of owners will be even more influential to performance. So even without inflationary complications, there will be winners and losers. The winners, though, will be determined by their ability to plan for the unknown.

Mitch Siegler is co-founder & senior managing director of Pathfinder Partners, a San Diego-based private equity firm specializing in value-add multifamily real estate investments in selected Western U.S. markets. For more information visit pathfinderfunds.com or email [email protected].