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Strategy Saturday
SS35: Why Is Real Estate A Great Inflation Hedge?
August 15, 2021
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SS35: Why Is Real Estate A Great Inflation Hedge?

Welcome to Strategy Saturday; I’m Charles Carillo and today we’re going to be discussing why is real estate a great inflation hedge?

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Transcript:

Charles:
Welcome to Strategy Saturday; I’m Charles Carillo and today we’re going to be discussing why is real estate a great inflation hedge? So if you turned on any news lately, especially financial news, it’s you hear every day about inflation. When is inflation going to start picking up more? We’ve already seen the beginning of inflation. So I want to do a podcast episode on just real estate inflation and how coincides with real estate. Number one, why hard assets and specifically commercial real estate are good. Inflation hedges. How well different types of real estate has historically stood up against inflation. And number three, how to best manage your real estate to boost returns during inflationary periods. I also want to do a little background on the CPI consumer price index, because a lot of people don’t understand what’s included in that basket. So why hard assets specifically commercial real estate are good inflation hedges while hard assets.

Charles:
When we talk about them, it’s precious metals, it’s commodities, it’s natural resources. So your water, your energy, and then also real estate. The value of all these hard assets, including real estate in particular is primarily derived from limited supply scarcity and tangible nature. They exist in a physical form as inflation occurs, whether it’s due to genuine economic growth, or is this most likely the case, monetary debasement and the price of everything scarce rises. So to do hard assets now, Lynn physical billing structures, both mashes subscription. So how does inflation affect real estate? Well, three different ways. Number one, property prices increase. We’ve already seen that. Number two, the cost of debt increases. We have not seen that yet. In number three, rental rates increase now rental rates and property prices usually coincide and ride off of one another. So that’s, it’s normal to see that the cost of debt though.

Charles:
We have not seen that. And that’ll be something that gets put into place by the fed to slow down inflation. If we get to that point, who knows if that will even happen. So how well the different types of real estate historically stand up against inflation. Now I, during our research, I found a very interesting article. I’ll link to it. It’s a historical MIT study and the observation is that only retail property income has been proven to keep up with inflation, industrial and apartment income provide a partial inflation edge while office property income provides virtually no inflation hedge. Now within this study, as you’re reading about it, you go, why, why would retail property keep up with inflation best out of all the different commercial real estate classes, and that’s most likely due to percentage rent leases. Now, if you don’t know what a percentage rent Leigh says, a percentage lease is a lease that requires a commercial space tend to pay a base rent.

Charles:
And on top of that to pay the landlord, a percentage that is based on business owners and monthly sales volumes, percentage leases are commonly executed in retail mall outlets and are usually about 7%. So how does that work? Well, if you were in one of these situations with percentage lease and you had a say a thousand dollars a month lease and in that thousand dollars a month lease, what happened was that, that that was your base rent. And then you pay, let’s say 7% on top of that, you had $10,000 worth of sales for that month. You would then be paying $700 on top of the $1,000 to your landlord. So in simple terms, this makes perfect sense. Why would hold up best? Because that landlords rent being paid to them is re being recalculated every month. So if that most likely in a business setting, if you’re buying goods and you’re buying goods last year for our last month for a thousand dollars, and this month, they cost a, 1,010 and then next month it’s 1,050 or whatever it might be.

Charles:
It’s increasing. You’re most likely going to increase your prices when you increase your prices, you’re most likely going to increase the total sales. So you were doing 10,000 this month and three months or four months from now, you’re now doing $11,000 a month. Well, now that landlord is being paid 7% on $11,000, not 7% on 10,000. So it’s a very, it’s a very, a regular increase in recalculation on the rent that’s being paid to that landlord. And that is not normal with office leases. Now office leases would be typically up 15%, every five years. So about 3% a year. Let’s just say that. And if there’s any type of let’s say hyperinflation, I won’t say that, but you know, a great increase in inflation during that time. You can see all of that property is not going to hold up with inflation because it might be several years before that landlord is, has the ability of renegotiating a new lease.

Charles:
Now with apartment income, this is something where usually it’s done on a 12 month period. So with that being said, it’s much easier to increase your rents with inflation every 12 months, not as nice as every month, like with a retail percentage lease, but every 12 months will allow your property to to hedge inflation. However, with that being said, the real appreciation rate of us real estate in general has been consistently higher than inflation for the past decade. So that’s great. A mash advisor article, which I’ll put into the show notes, talks about how over the last decade, we’ve seen real appreciation of us real estate outperform the inflation as well. So that’s a great thing to know as well. And that’s why it’s a great hedge. Now, how do you best manage your real estate that boost returns during inflationary periods? Some possible options include introducing periodic rent reviews, maybe semi-annually or perhaps even quarterly, if a commercial property.

Charles:
Now you’d have to have the tenants agree to this, but these are all ideas with residential real estate. As we spoke about before the one-year leases are typical and allow managers to reprice units at market rates. It is typical though, with residential managers to obtain a partial increase in market rent when renewing good tenants, for example last year it was a thousand dollars a month for rent. The market is now 1100. You raise it to 10 50, a 5% increase versus 10% in Greece because you want to keep that tenant because there might other, there it’s very normal that there’s other landlords event aren’t as good managers of you. They might just be letting people renew at zero increase, 3% increase. So you want to be competitive because you have to always put into consideration. I’m going to get an extra $600 a year in rent when I increase it 10% versus 5%.

Charles:
However, if this unit is vacant for one month and then if it’s vacant for that one month and I have to do, let’s say one more month worth of work to it. Well, that’s thousands of dollars that I’ll be out just to try to get this extra $50 a month when the person moves out and we, and you do a turn on it, right? And then make ready on the unit and you release it. That’s when you can really capture the full market rate. But it’s definitely done to do a slight increase with good tenants. Obviously it’s good tenants being the operative term there where you’re able to keep them while also capturing some of the market increase in in, in the rent. Now, also with that being said, just because you’re, the rent goes up 5% or 10%. It doesn’t mean all your expenses are going to go up that high.

Charles:
You know, you’re going to have, obviously a lot of your debt’s going to be fixed but you might have some other expenses say operating expenses, but you know, I have insurance. These are going to go up, but it’s a small percentage of what you’re paying on your overall operating costs because the largest percentage is really your debt. Now, if you introduce a rental lease like a CPI indexation or another similar in next, but a more accurate index as such clauses were common in rental leases in the high inflationary periods of the 1970s and 1980s. This is a more prevalent with commercial leases in extreme inflationary periods. And, you know, inflation 1980 was 14.7, 6%. This is not something you’re going to be getting in a residential lease. But if we really start seeing consistent inflationary, maybe extreme inflation, you’re probably see some of these clauses come back.

Charles:
Now, what else can you do? You can pay down any existing property, really debt. If you have a variable debt and steer clear of new debt, because as inflation, it also increases the cost of borrowing. Or if, you know, if you’ve been listening to the show, you know, that I really am a big fan of fixed debt. If you have fixed longterm debt on your property, you can weather almost any storm, including inflation. And now if you’re getting debt for 3% and say inflation to 6%, I mean, every time every month you pay your, your mortgage, you are, I mean, you’re paying with dollars that are cheaper, that are worth less month, two, then month one. And that goes for year five, right? Much cheaper dollars than it was a year one. Now a little background on CPI. As we wrap up here, the CPI, the consumer price index was initiated during world war one and reflected the relative importance of goods and services purchased in 92 different industrial centers in 1917 to 1919, particularly in ship building centers.

Charles:
And it made an essential and index essential for calculating cost of living adjustments in wages in January, 1983, housing prices were replaced with owner’s equivalent of rent. Now this is part of the CPI. So pre January, 1983 is actually housing prices were in the CPI. And as of January, 1983, housing prices were replaced with owner’s equivalent of rent because rents are more stable. And because how housing prices rose and fell more than rents during the housing bubble and crash housing effects on inflation, deflation are not reflected in the CPI. So it’s very important to know that there’s 85,000 items in the CPI. 22,000 stores in 35,000 rental units are added together and average, there are weighted at this way, housing 41.4% food and beverage 17.4% transport, 17% medical care, 6.9% apparel, 6% entertainment, 4.4% and other 6.9%. So it’s very important that housing 41.4% that’s how important housing is and how it’s viewed by economists and how important it is to inflation in our economy. So I’ll put all the links into the show notes. Thank you so much for listening. Please remember to rate, review, subscribe, submit comments, and potential show topics at global investors, podcast.com. Look forward to two more episodes next week.

Speaker 3:
Nothing in this episode should be considered specific, personal or professional advice. Any investment opportunities mentioned on this podcast are limited to accredited investors. Any investments will only be made with proper disclosure subscription documentation and are subject to all applicable laws. Please consult an appropriate tax, legal real estate, financial or business professional for individualized advice. Opinions of guests are their own information is not guaranteed. All investment strategies have the potential for profit or loss. The host is operating on behalf of Syndication Superstars, LLC, exclusively.

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