Recently, the U.S. labor department data suggested that the annual inflation rate in the US accelerated to 9.1% in June of 2022, the highest since November 1981.
Inflation is a volatile variable when it comes to managing your portfolio. The effects of inflation can devastate your assets, as we have seen in the wake of a downturned economy, war, political unrest, a disturbance in resource availability, or a chilling response to a surging global pandemic.
Inflation means that your money doesn’t go as far as it used to. This is true whether you like it or not, and while nobody likes losing money, some people always seem to profit from inflation. What do they know that we don’t know?
Multifamily real estate can be an excellent hedge against inflation. To understand why it’s essential to know how inflation works and how it affects the value of money. And when you know those things, you may discover that multifamily real estate can help you protect yourself from inflation’s adverse effects—and even profit from it.
Before you begin to understand how residential real estate appraisals differ from commercial multifamily appraisals, it’s important to understand the different approaches these two types of properties take in arriving at their values.
Commercial vs. Residential Appraisals
Commercial real estate, unlike residential, is appraised using the income method. The more income property brings in, the more it is worth.
The commercial real estate valuation formula is Value = Net Operating Income / Capitalization Rate.
Net Operating Income (NOI) equals all revenue from the property (all rents, fees, and other income), minus all reasonably necessary operating expenses.
Capitalization Rate (Cap rate) indicates the rate of return that is expected to be generated on a real estate investment property.
Cap rates are expressed as percentages and vary from market to market. Within each market, cap rates have a historical range. For example, if a property had $300,000 in NOI and the cap rate in that market was 5%, you’d expect it to be valued at around $10 million ($300,000 / 5% = $6 million).
Have You Heard About C.A.P.T?
Among the key concepts, you should be familiar with are cash flow, appreciation, principal paydown, and tax benefits. Cash flow is the current and ongoing payments to the investor from rents. It is also referred to as yield. In addition to yield, there is equity growth from the appreciation of the property and paying down the mortgage each month. This equity component is realized upon liquidation of an apartment building—we’ll look at an example below to see why this makes apartment investments so attractive.
Multifamily real estate has a long track record of beating inflation. Over the last 43 years, multifamily has beaten the inflation rate 37 times. In comparison, the S&P 500 has only beaten inflation 29 times. How can multifamily 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 (case #1)
- 5% rent growth (case #2)
- 3% rent growth (case #3)
Case #1 – High Inflation / Higher Rent Growth
When inflation rises, apartment rents tend to rise even more quickly. Since multifamily properties have short lease contracts—typically no longer than one year—they are nimble enough to respond to inflationary pressures and raise their rents in response. This is a real benefit for 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. As a result, the only way for them to achieve higher rent growth than CPI is through the re-leasing property at higher rates than those specified in their leases.
In this case, 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
Our NOI increased by $45,000, so it is clear that our 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
Case #2 When High Rent Growth Equals/Keeps Up With High Inflation
In this case, 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
Even when rent growth merely keeps up with inflation, the investor still wins (and profits from inflation). An increase in income of 5% equates to a less than $42 increase in rent for each unit per month. The owner’s expenses also went up 5%, costing him or her less than $21 per unit.
The increase in yield is cash in your pocket as well as an increase in the equity value of the property. Everybody wins here.
Case #3 When the Rent Growth Lags behind High Inflation
In the two previous examples, investors benefited from the effects of inflation. But what would happen if rent growth could not keep up with inflation? Would inflation win? Would we be stuck losing money? Let’s redo the math for an inflation rate 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
While it may seem counterintuitive to achieve both higher yields and increased equity, the fact of the matter is that B-grade commercial multifamily real estate has expenses that are around half of the income it generates. So even in the worst-case scenario, this fact helps offset the effects of inflation on apartment investments.
So Is it a Good Time to Invest in Real Estate?
The answer to the question above is yes. It is a very good time to invest in real estate and here are FIVE reasons why.
- Investing in hard assets of value, such as real estate, protects one against inflation.
- Investing in appreciating assets with positive returns counters the effects of inflation, which can cause negative returns.
- Rates are still very low (We had 17% interest rates in the 80s!).
- Home ownership is declining, leading to increased demand for rental properties.
- Rental growth has increased yearly and is expected to continue through at least the next three years.