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Rising Costs, Inflation & the Importance of Reserves for your Rental Property Business

Rising Costs, Inflation & the Importance of Reserves for your Rental Property Business

Agnes A. Gaddis

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As the brisk autumn wind of 2023 replaces the sweltering heat of summer, a not-so-familiar chill can be felt within the U.S. economic landscape: inflation. The U.S. Labor Department recently reported that the annual inflation rate clocked in at a steady 3.7% over the 12 months that ended in August, spurred in significant part by gasoline prices. It’s much like watching the seasons change, but this time, it’s the monetary climate that’s causing a stir.

For real estate investors, understanding how inflation affects rent and other facets of the housing market is crucial. With inflation, the value of money decreases, and the cost of goods and services increases. This means that to turn a profit on a property, its value must increase faster than inflation and the interest rate on the loan. In other words, real estate investors need to aim for a minimum of 6% annual appreciation, and ideally, double-digit growth.

To succeed in this inflationary environment, real estate investors must be strategic in their approach. They need to identify areas that are likely to experience growth and demand in the near term. This can be achieved by evaluating factors such as job creation, population growth, government planning, affordability, absorption rate, and vacancy rate.

In addition, rental properties, including residential, commercial, multi-unit, and single-family homes, are likely to be in high demand during periods of high inflation. This makes them an attractive investment opportunity. Real estate thus emerges as a sturdy hedge against inflation. But it’s important to optimize these investments for better cash flow.

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This post will delve deep into the intricate relationship between inflation and real estate, addressing questions like how does inflation affect rent and exploring strategies investors can adopt to protect their real estate investments against inflation. Additionally, we will shed light on the significance of having reserves for your rental business as a means to smooth-sail through the current housing market landscape. Let’s get started!

The Most Significant Effect of Rising Inflation

The most significant effect of rising inflation is the loss of purchasing power. This occurs when prices increase across the economy, leading to a decrease in the value of money and the capacity of consumers to purchase goods and services.
Inflation from 1998 to 2022 Investopedia

Image Source: Investopedia

In the United States, chief indicators of inflation are the Consumer Price Index (CPI), the Producer Price Index (PPI), and the Personal Consumption Expenditures Price Index (PCE). These indices track the fluctuations in prices that both consumers and producers experience within various sectors throughout the American economy.

Regardless of the inflation rate, whether it is 2% or 4%—consumers lose purchasing power. In the case of a 4% inflation rate, the decline in purchasing power is twice as rapid as it would be at 2%. This understanding is vital, as it clarifies how inflation influences not just the prices of everyday groceries or the value of the dollar in one’s wallet, but every facet of the economy. In the long run, inflation can significantly dent investment returns.

In an inflationary environment, the uneven ascent of prices contributes to the erosion of real income for some consumers. This loss of purchasing power constitutes the single largest cost of inflation. The concept of purchasing power affects every aspect of economics, from consumers acquiring goods and services to investors purchasing stocks, and even extends to a country’s overall economic prosperity.

Who Benefits When Inflation Rises Quickly?

During inflation, while the majority of people may struggle to keep up with the rising cost of living, there are certain groups who can capitalize on the situation and even thrive. Here are four categories of people who tend to benefit most from inflation.

1. Real estate and physical asset investors

Real estate and physical asset investors often profit during periods of high inflation. This is primarily because these tangible assets, like land or collectibles, tend to increase in value compared to liquid assets like savings that quickly lose value with inflation.

Real estate demand often rises during inflation, leading to higher property prices. How does inflation affect rents? Rental property owners reap benefits by raising rents, which, when coupled with a fixed mortgage, may result in increased real income.

Collectibles such as fine art, wine, or baseball cards also gain value during inflation. As the dollar’s purchasing power decreases, investors typically divert to these hard assets for their resilience in holding value amidst market volatility. Thus, they provide a reliable hedge against inflation, benefiting their owners significantly during these times.

2. Borrowers with fixed-rate loans

Borrowers with fixed-rate loans can benefit during periods of inflation because the real interest rate (the nominal rate minus the inflation rate) becomes lower or even zero. This means that the borrower’s monthly payments remain the same, but the purchasing power of the money they owe decreases over time. As a result, the borrower’s debt becomes easier to repay, especially if their income keeps pace with inflation.

3. Energy sector investors

Energy sector investors often benefit during inflation as energy demand remains persistent despite rising costs. Consumers and producers still require energy resources like gas for transportation and electricity to power operations, ensuring that energy demand remains stable even in inflationary times.

Additionally, current global factors such as increased investments in clean energy, climate change initiatives, supply chain challenges, labor shortages, geopolitical tensions, and the lingering effects of the Covid-19 pandemic, contribute to the potential for energy sector stocks to gain value and lead the market. Therefore, investors in this sector can benefit by capitalizing on the enduring energy demand and market dynamics arising from these factors.

4. Loan investors

Investors in loans, such as leveraged loans, mortgage-backed securities (MBS), and collateralized debt obligations (CDOs), can benefit during periods of inflation due to the floating-rate nature of these instruments. As inflation rises, the interest rates charged on these loans can also increase, allowing the return on investment (ROI) to keep pace with inflation. This means that investors can earn a higher return on their investment, which can help offset the negative effects of inflation on their purchasing power.

Additionally, MBS and CDOs can provide diversification benefits, as they are backed by a pool of mortgages or consumer loans, which can help to reduce risk. However, it’s important to note that these investments can be somewhat risky, depending on their rating, and may require a fairly large minimum investment.

How Does Inflation Affect Real Estate Prices and Rents?

Inflation can have a positive impact on real estate prices and rents.

During periods of high inflation, the cost of borrowing funds increases, which can lead to higher interest rates for borrowers and tighter underwriting standards. This can make it more difficult for people to obtain loans, which can slow down the development of new real estate projects. As a result, property supply decreases, leading to higher property values and rents.

Additionally, as inflation pushes up the prices of all goods and services, including housing, rents also increase. With fewer new properties being built, demand for existing properties rises, leading to higher occupancy rates. Landlords can then raise rents, generating higher revenues.

Furthermore, real estate investments, particularly rental properties and multifamily units, have historically performed well in a rising rate environment. They have shown a greater ability to grow net income during expansionary periods than securities and other assets. This resilience of real estate assets makes real estate an inflation hedge for many investors.

It’s important to note that while inflation can lead to higher real estate prices and rents, it’s not always a straightforward relationship. Other factors such as changes in government policies, economic conditions, and demographic trends can also impact the real estate market.

Inflation and the Stock Market

Inflation generally has a negative impact on the stock market, causing uncertainties, reduced gains, fluctuating performances, and affecting growth stocks more severely.

During inflation, markets experience uncertainty due to factors such as interest rate hikes and the underlying macroeconomic events that contribute to rising costs. As a consequence, key stock indices like the S&P 500 are likely to exhibit increased volatility and weaker overall returns, especially if the inflationary conditions come suddenly and unexpectedly.

Growth stocks tend to be highly sensitive to rising interest rates as their future earnings are typically valued using discounted cash flow models. With higher current interest rates, these models assign lesser value to growth stocks’ future cash flows.

However, some companies might be able to pass on the increased costs to consumers through higher prices while maintaining or even expanding their profit margins. This ability, called “pricing power,” is more common in sectors such as food and energy, as their offerings are essential to consumers.

On the other hand, the bond market incorporates inflation expectations into its pricing models, with bonds generally priced to offer real returns on top of anticipated inflation rates. When inflation persists, bond investors demand higher interest rates to ensure their assets maintain or grow in purchasing power. This situation leads to a decrease in the value of existing bonds with lower rates and higher interest costs for new bond issuances.

Central banks are often hesitant to allow unchecked inflation to drive prices higher primarily due to these adverse impacts on the bonds and financial markets.

Does the Federal Reserve Want Inflation?

The answer to the question is yes, the Federal Reserve wants inflation, but not too much of it. The Fed’s dual mandate includes maintaining maximum employment and keeping prices stable, and it uses inflation targeting to achieve these goals. By setting an inflation target of 2%, the Fed aims to create a stable economic environment that fosters economic growth and improved employment opportunities.

High inflation can lead to decreased purchasing power and reduced economic activity, while low inflation can lead to deflation, which can also have negative economic consequences.

It’s worth mentioning that the Fed’s inflation target is not a hard and fast rule. The Fed has the flexibility to adjust its inflation target in response to changing economic conditions. For example, during times of economic downturn, the Fed may tolerate a slightly higher level of inflation to help stimulate economic growth. Conversely, during times of economic growth, the Fed may aim for a lower inflation level to prevent the economy from overheating.

A key tool in the Federal Reserve’s arsenal to control inflation is influencing interest rates. High inflation typically invites a response from the Fed in the form of raised interest rates to slow down the economy and bring inflation under control.

Since January 2012, the Fed’s target for inflation has been set at 2% as part of its dual mandate. This move was seen as an attempt to align with the single-mandate goal of price stability pursued by the European Central Bank. By adhering to this specific inflation target, the Fed aims to foster a stable economic environment conducive to maintaining maximum sustainable employment

Strategies for Protecting Your Rental Property Business from Inflation

Now let’s explore some effective strategies for protecting your rental property business from the negative effects of inflation while also taking advantage of its potential benefits

1. Diversify your investments

Diversifying your investments is a strategy that can protect a rental property business from inflation by spreading risk across different assets, strategies, or asset classes. This approach can help reduce the impact of inflation on your portfolio by lowering short-term volatility risk and potentially improving long-term value. By investing in a variety of assets, such as residential and commercial properties, vacation rentals, and properties in different locations, you can create a balanced portfolio that can weather the effects of inflation.

For example, if inflation causes the value of one property to decrease, gains in other properties can help offset the loss. Additionally, investing in properties in different locations can provide a hedge against local market fluctuations. By diversifying your investments, you can reduce your reliance on any single property or market, making your rental property business more resilient to inflationary pressures.

In today’s digital age, it’s easier than ever to invest in properties remotely, allowing investors to expand their reach beyond their local market. With 3D floor plans and online walkthroughs, investors can explore properties from the comfort of their own home, making it easier to diversify their portfolio and protect their rental property business from inflation.

2. Focus on rental cash flow

In times of high inflation, rental properties can transform into golden geese for investors, delivering consistent and durable profits. One way to beat inflation and, in fact, capitalize on it is by enhancing your rental cash flow.

For landlords with annual rental agreements, inflation presents more opportunities than threats. Unlike commercial properties, usually burdened by leases spanning five to ten years or longer, residential properties often involve shorter, one-year leases. This shorter lease span allows residential property landlords to adjust their rents in sync with inflation, ramping up their rental income with the rise in consumer price index.

To further bolster your cash flow, consider monetizing specific features or amenities of your rental property. For instance, a detached garage, not typically included in the rent, can be rented separately, adding a significant amount to your monthly cash flow. Features like these can often translate into an additional $100 or more per month in many real estate markets.

3. Consider creative financing options

When faced with the challenges of acquiring new rental properties, such as high upfront costs related to down payments, even the most financially secure investors can hit a wall. In an inflationary environment, this hurdle grows even higher. This is when exploring alternative, creative financing options can be a valuable strategy, enabling you to secure new rental properties and expand your portfolio.

Creative financing is an approach to funding a real estate acquisition without relying on traditional loans and down payment structures. Several financing options may be considered, including:

  • Cash
  • Home Equity Line of Credit (HELOC)
  • Security Backed Line of Credit (SBLOC)
  • 401k loan
  • Owner financing
  • Private money loans (from friends or family)
  • Hard money loans
  • Syndications

By exploring these non-conventional funding sources, you can bolster your real estate portfolio, snatch up profitable properties, and ultimately mitigate the consequences of inflation on your rental property business.

4. Optimize your tenant screening process

An essential aspect of safeguarding your rental property business from inflation involves minimizing tenant turnover and assuring a steady and secure rental income. By optimizing your tenant screening process, you not only attract high-quality, reliable tenants but also reduce the costs and potential losses associated with frequent tenant replacements.

A primary consideration during tenant screening is ensuring that applicants have a stable and sufficient income to afford the rent. As a guideline, an applicant’s combined income should amount to at least 2.5 to 3 times the monthly rent. For instance, if the total monthly rent is $1,000, the combined income should be $3,000 or more per month.

To verify income, your application form should request attachments such as pay stubs or W2 forms. If applicants are self-employed, they should provide at least two months’ worth of pay stubs. This process aims to cross-check the declared income with the supporting documents, ensuring your tenants can consistently meet their rental obligations.

By refining your tenant screening process, you can secure dependable tenants who contribute towards unwavering cash flow, mitigating the ill effects of inflation on your rental property business.

5. Have a rental property cash reserve

During times of inflation, financial volatility can be just around the corner for many businesses, particularly real estate.

As a landlord, it’s not uncommon to face significant anticipated and unexpected expenses. Unpredictable costs can range from significant repairs and large-scale renovations to the financial drain of lengthy evictions and prolonged vacancies. In such scenarios, lacking a robust cash reserve could leave you in precarious straits, potentially even forcing the distress sale of your property at a compromised value.

A sound strategy is to establish a robust fund set aside explicitly for these challenges – often referred to as a rental property cash reserve. A good rule of thumb suggests keeping approximately 10% of the annual rent per property in reserves for maintenance and repair work. This functions as a safety cushion, preparing you for any financial blows.

A more tailored approach would involve outlining all your recurring monthly expenses, including mortgage, taxes, insurance, property management, lawn care, utilities, and so forth, and setting aside 3 to 6 months’ worth. This practice ensures you always have a financial buffer against unforeseen expenditures or temporary income shortfalls.

The Importance of Reserves for Your Rental Property Business

Having a reserve fund for your rental property business is essential in managing financial challenges, including those brought upon by inflation. Potential issues such as increased maintenance costs and temporary revenue decline may arise due to inflation, including rent fluctuations. Establishing a reserve fund can help you accomplish your goal of using real estate as an inflation hedge, securing your business against unexpected financial burdens.

Handling emergency repairs
The age-old adage, “expect the unexpected,” rings especially true in the rental property business. Operating such a business often means coping with sudden, unforeseen repairs that require immediate attention. A reserve fund is your invaluable ally in these situations.

Critical emergencies such as a burst pipe, electrical mishaps, sewer backups, leaky roofs, and malfunctioning appliances can be distressing and financially draining. These urgent issues demand prompt resolution, sparing little time for financial strategizing. Having a reserve fund ensures that you can address these emergency repairs head on, without disrupting your cash flow.

Vacancy coverage
In the lifecycle of rental property businesses, tenant vacancies aren’t an anomaly but an inherent part of the journey. From the time one tenant leaves until the next moves in, there’s usually a window when the property remains unoccupied and devoid of rent revenue. However, recurring expenses such as mortgage payments, taxes, and utility bills don’t pause. This is where your robust reserve fund steps in, shouldering the financial load during these vacancies.

The reserve fund is designed to mitigate the implications of these void periods across all your properties. It acts as a financial cushion, ensuring that you can comfortably cover all ongoing costs and maintain the upkeep of your properties even when rental income temporarily halts.

While vacancy rates can vary regionally, as shown in reports like the U.S. Census Housing Vacancy Survey, a well-stocked reserve fund ensures that these periods don’t impact your financial stability or disrupt your rental property business.

Legal and compliance costs
Landlords can sometimes be entangled in lengthy legal processes like evictions or fines resulting from unintentional violations of local tenancy laws or building codes. Balancing these unexpected and often substantial costs can be a formidable challenge for any landlord.

A substantial reserve fund, though, transforms this potential stumbling block into a manageable hurdle. It ensures you have a predetermined financial resource to lean on in such instances.

Safety net for unexpected expenses
Events like natural disasters don’t adhere to a timeline and can wreak havoc on your business operations, shuttering doors, and potentially causing extensive property damage. In the wake of such an event, you may find yourself grappling with a gaping hole in your finances.

It’s likely that your landlord insurance policy doesn’t cover such unprecedented risks entirely. Your reserve fund can bridge this coverage gap, lessening the financial damage and providing a buffer against such unexpected outflows.

Knowing how inflation affects rent dynamics and real estate prices is crucial for rental property business owners. Anticipating possible challenges posed by inflation and creating a robust reserve fund is essential in navigating these complexitiesYou might also want to check out these 12 property management tips for landlords in 2023.

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