WHAT MIGHT INFLATION DO TO YOUR MULTIFAMILY INVESTMENT?

Keep your eyes open during the current economic turbulence.

Eggs will cost you more today than they did yesterday. So will most everything else. It is called inflation.

What will inflation do to your multifamily investment?

I don’t know.  No one else does either.

What we do know are, first, what has happened in the past and, second, what some of the major forces are that impact our investments in apartments.  

Let’s look at these two.  But, first, a quick attempt to understand what inflation is.

WHAT IS INFLATION?

A dollar will buy 2 eggs today, according to the sign in the picture. Previously that dollar would have bought 4 eggs. That is inflation. A dollar doesn’t go as far as it used to go.

Less than a year ago I spent $50 to fill up my gas tank.  Just this week, I had to spend $75 to do the same thing.  My gas dollars don’t buy as much gas as they used to.  Same with my grocery dollars.  

Inflation happens when the prices for goods and services are rising.  This means your money has less and less purchasing power.  Your dollars just don’t get you as much as they did a while back.

Milk, meat, bread, just about everything is costing more.  Employers have been required to pay more per employee hour.  That is what inflation does.

The United States Annual Inflation Rate was 2.3% in 2019, 1.4% in 2020, 7% in 2021, and as of June 2022 it has risen to 8.6% (according to U.S. Labor Department data published June 10, 2022).

Fear about inflation is all over the news.  Perhaps you are feeling it. 

What will it do to your lifestyle?  If you have a fixed amount of retirement dollars, they won’t go as far as before.

What will it do to your investments, in particular your multifamily investments? Some people will be losers during the inflation ahead. Others can actually grow their investments to keep up with or win out over inflation’s effects.

HISTORY OF INFLATION, ITS IMPACT, AND MULTIFAMILY INVESTMENTS

Multifamily investments have demonstrated over many decades to be an excellent hedge against inflation. 

By hedge, I mean this asset class can reduce the negative effects of inflation on your investment dollars.

Multifamily investments have a track record of beating inflation 86% of the time over the past 43 years. The S&P has beat inflation about 67% of the time over the same period. This asset class holds up well during inflationary periods.

RISING RENTS.  One of the reasons is because when inflation rises, rents also tend to rise, along with everything else.  Because leases in apartments are normally 12 months in length, apartments can raise rents fairly quickly and meet or beat the rising costs of operating the apartments (utilities, labor, supplies, etc.).

CHECK THIS OUT. Suppose inflation remains at 8%.  Assume the expenses of running the apartments increase by the same percentage, 8%.    If we raise the rents by 8% and the cost of operating is raised by 8% also.  On the surface, it seems we would be just breaking even. 

Let’s say the rent is $1000 per month and you are able to raise the rent 8%.  This would increase the rent to $1080 per month, an extra $80 per month.  

The normal operating expenses for an apartment complex are about 50% of the rental income.  So, the expenses are about $500 for the rent of $1000.  Make sense?  If inflation is 8% on the expenses, the total cost for expenses would rise to $540 a month, an extra $40 per month.  

In reality, you have a net increase of income of $40 a month, ($80 income minus $40 expenses).

So, you have a choice of not raising rents as high or of increasing your net operating income in a time of inflation.  

In addition, the mortgages on most apartment complexes have fixed interest rates, keeping any debt service payments stable as rents increase.  

DEMAND FOR APARTMENTS.  A second reason multifamily investments tend to do well during inflationary periods is the increase in demand for apartments.

Inflation makes the purchase of a home more expensive, even out of reach for some of those who would like to purchase a home.  So, demand for rentals increases.  

The current housing market has a shortage of approximately 5 million units.  Currently, supply and demand is on the side of the owners of apartment complexes.

DEMAND FOR MULTIFAMILY INVESTMENTS.  A third reason is a demand by other investors to participate in the multifamily space.  

Many wise investors, like you, see the potential of these investments to be an excellent hedge against inflation.  Therefore, the value of apartment complexes usually remains quite stable during times of inflation.  Multifamily loan originations were up over 50% during the last three quarters of 2021.

The fundamentals are favorable for owning apartment complexes.  Many other investors see this and are helping to maintain demand for the purchase of available complexes, keeping their values high.

STABILITY OF MULTIFAMILY INVESTMENTS.  Apartment complexes have maintained their value and even increased in value year-over-year for the last 40 years, with a few exceptions.  The volatility of multifamily values is quite low compared with the volatility of many other investment classes.

MAJOR FORCES TO WATCH TODAY

Past performance and wishful thinking are no guarantees that a multifamily investment will be a sure thing during the years ahead.  There are many factors you and I will keep our eyes on as we analyze our investment in apartments.

BUYING RIGHT.  With the prices for apartment complexes rising as fast as they are, it could be easy to pay too much.  As the old saying goes, the profit is made in the purchase.  One thing to watch for is to do appropriate underwriting of the deal prior to purchase.

Good deals can be made in every kind of market.  Sometimes this means being creative.  Negotiating favorable terms with a seller can make a challenging deal possible in these challenging times. 

Both the seller and the purchaser can win, when negotiating well. We were talking with an investor friend who said they were able to make an offer on an apartment complex above the asking price with a creative set of terms, which would increase the returns for both the seller and for them as buyers.

THE INVESTMENT TEAM.  As always, the quality of the investment and operating team is critical in any deal.  Getting the right professionals on the team is a key – including the accountants, lawyers, contractors, property managers, and private money partners.

CAP RATES.  Some investors are concerned that CAP Rates will rise as the Fed Rate rises.  The two are definitely connected.  As the cost of borrowing increases, it is quite possible the rate investors will want to achieve on their capital investments will also rise.  

As CAP Rates rise, assuming a fixed net operating income, it is assumed the value of the properties will correspondingly go down.  Even with higher rents and increased operating incomes that follow the higher rental income, the actual value of the multifamily properties may go down.  

This is something to seriously consider.

It is also possible that with a well-managed property, the increase in income will have a positive impact on the value of the asset overall.

Historically, multifamily properties rents rise during inflationary times.  This has also meant a rise in the property values as well, even with some adjustments in CAP Rates.

Jamie Woodwell, the Vice President of Commercial Real Estate Research at the Mortgage Bankers Association says, “The change in interest rates is not expected to reduce demand for multifamily housing this year.  A lot of demand is driven by property values and fundamentals, both of which are extremely strong…”  

Researchers at CBRE have noted that CAP Rates and the Fed Rate don’t necessarily move in tandem.  CAP Rates may even compress some more, according to Matt Vance of CBRE.

THE HOUSING SHORTAGE.  We mentioned this previously.  The demand for housing, both for purchase and for rental is strong, particularly in the South and Southwest.  This may change.  Many potential home owners are priced out of purchasing and are renting instead, leading to demand outstripping supply in apartments and a subsequent increase in rents.  

We always watch for new construction of multifamily housing in the market and the number of units planned to come online.  Too much supply can be a problem, leading to increasing vacancy rates in some complexes or requiring a reduction in rents.

RECESSION.  This article does not address the impact of a possible economic recession in the near term.  A recession would create other issues.  We’ll explore that in a future blog.

CONCLUSION

Inflation is here and it is a real challenge.  Those who have studied the different asset classes have realized how well multifamily does during periods of high inflation.  

We outlined in this blog the definition of inflation, the history of how well multifamily does during times of inflation, and some of the key factors to watch as we make or hold onto our investments in apartments.

Hopefully, you, like some others, have realized that multifamily investments can be an excellent hedge during inflationary periods.

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