628: Recession-Proof Real Estate Investments

SHOW NOTES FOR EPISODE 628: RECESSION-PROOF REAL ESTATE INVESTMENTS

The impact of inflation has affected every aspect of our society.  But what about real estate investing?  In this episode, Bill shares specific real estate investing strategies that thrive during recessions and inflationary times.

Introduction

Everyone is talking about inflation these days. Knowing that products and services you buy are going to cost more can be frightening, especially if you’re locked into an income that doesn’t keep pace with inflation. Paying more for toothpaste may be the least of your worries, as retirement accounts take the biggest hit when the value of the dollar decreases.

What is Inflation?

Inflation is an average increase in the prices for a collection of goods and services in a given economy over a set period of time, usually calculated by year. Essentially, it’s the decrease in the purchasing power of the dollar over time. Taking what used to be our average rate of 1.8% inflation, the $400 washing machine you bought last year will likely cost you an additional $7.20 today. While that may not seem like much, when you add costs up for all your purchases, including groceries, gas, phone bills, massages, etc. over a year, you’ll have a much higher number and higher cost for goods over time. But, as we are experiencing inflation estimated to be between 6 and 9%, it could have an even bigger impact.

It’s important to note that inflation is not appreciation. An appreciation rate, as it relates to real estate, is the increase of a property’s value over time. With appreciation, value does not increase in relation to the currency, it increases based on demand. You can have scenarios where a home appreciates more than the inflation rate, and alternatively you can have it depreciate in an inflationary economy.

How Does it Affect Real Estate?

Probable positives during times of high inflation are rising prices for rental property rates. During high inflationary times, it can be difficult to get a mortgage. High-cost mortgage rates mean buyers have less purchasing power, so many continue to rent. This surge in demand results in increased rental rates, which is great for landlords. And while appreciation is a distinct and separate market analysis, in general, housing prices tend to rise in an inflationary economy. Real estate has intrinsic value; people need to have roofs over their heads regardless of the value of their currency. If you’re able to offer favorable terms for private mortgages, you’ll likely have a line out the door.

Potential negatives for a real estate investor in inflationary times is the increased cost of borrowing debt. To make sure the bank doesn’t get shorted, they’ll charge higher interest rates and offer fewer loans. Increased costs of building materials for new homes is another disadvantage. Between the high cost to borrow and the additional cost to build, new construction can be a very difficult investment during inflation. When pockets get tight, travel usually gets cut from the budget pretty quickly. Vacation rentals, locations that are driven by tourism, or retirement communities may not fare as well as other forms of real estate investing.

Inflation Can Diminish The Purchasing Power Of Retirement Accounts

Where inflation is truly dangerous to the average person is in retirement savings. It can be the slow silent drain that reduces the purchasing power of retirement dollars.

While the Federal Reserve believes that a 2% inflation rate is an indicator of a healthy economy, as of February 2022, inflation had risen to 7.9%. Let’s look at an example. Say that many years ago you placed funds into your 401(k) or IRA and allocated it to stocks. From 1999 to 2019, returns of the S&P 500 averaged 5.9%. This means that today, due to inflation, you would barely break even and should expect a loss after paying taxes. In addition, in years past, inflation in the US has risen to levels above 20%. The higher the rate of inflation, the more purchasing power you lose over time, even as the dollars in your accounts increase.

How Then Should We Invest?

As a general rule, real estate investments — such as rental properties or stock-based investments like real estate investment trusts (REITs) — tend to hold up well in inflationary environments. Property values and rental income both tend to keep up with inflation over time, and the investment vehicles that invest in real estate tend to outperform the market during inflationary periods.

In 2021, inflation reached its highest level in 40 years, and REITs as a group outperformed the S&P 500 by nearly 13 percentage points. And in the modern era, REITs tend to underperform the market when inflation is 2.5% or lower, but handily outperform when inflation is 7% or higher, as it is now.

3 Types of Real Estate Investments That Can Thrive with High Inflation in 2022

Generally speaking, real estate tends to hold up well against inflation, as I just mentioned. But it’s important to realize that there are many different subsectors of real estate, and not all have the same inflation resistance. The real estate investments that tend to perform best in inflationary environments have the following characteristics:

Short lease duration: Some types of commercial properties use long-term leases that have small annual rent increases built in, while others are shorter-duration and reset to market rates more frequently. Those in the latter category tend to perform better during inflationary periods. Airbnbs, for example, have short-term leases and are currently thriving.

Pricing power: Inflation-resistant investments typically have the ability to pass price increases along to their customers. As an example, apartment REITs are an essential type of property (people need places to live), which gives landlords the ability to raise rent along with the market. On the other hand, shopping mall REITs might be less flexible, as rapid rent increases could cause some tenants to think twice about keeping their stores open.

Resilient demand: Shorter lease durations don’t help if you can’t find enough tenants to fill your properties. So, it’s smart to consider properties that will remain in demand even if prices rise. Think industrial real estate — the surge in e-commerce has created such a need for logistics real estate that industrial REITs simply can’t build properties fast enough.

Here are some of the top real estate investment categories for high inflation.  I will also include podcasts and/or blog articles that go into details on these areas.

• Residential rentals: This can either mean owning actual investment properties, buying residential REITs, investing in multifamily syndications or investing in Build-to-Rent Funds.  Residential property values and rent tend to keep up with inflation over time, and the essential nature of the properties tends to make them rather recession-resistant.
• Industrial properties: We have mentioned this category a number of times on this podcast.  Industrial tenants tend to sign long-term leases, the demand for this type of property is simply off the charts right now, giving operators excellent pricing power when leasing, renewing, or releasing.
• Hospitality: Hotels and Airbnb have the shortest “lease” durations of any commercial property type as they have the ability to change their room rates on a daily basis. With a combination of high demand for travel as COVID-19 restrictions wind down and the ability to raise prices with inflation.
• Farm Land: Any commodity-based investments will be strong during inflationary times because, like real estate rentals are strong because people need a place to live, commodities remain strong because people also need to eat.  Over the past several decades, farmland returns have moved in strong correlation with rising prices. Farmland has historically held a 70-percent correlation to the CPI and an almost 80-percent correlation with the Producer Price Index. Agriculture investments have also had a stronger relationship to inflation indexes than traditional investments. In the past, commodities had a stronger correlation to inflation than U.S. equities, international equities, bonds, real estate, and gold.
• Self-Storage: Self-storage is arguably the best real estate industry to be invested in during a recession. Self-storage, at its core, is in the business of distress. Circumstances like divorce, relocation, death, unemployment, foreclosures, or downsizing are some of the common drivers for people to store their things in a self-storage facility. Most of these are common outcomes regardless of a recession or not.  During the Great Recession, from 2008 to 2012, the four major publicly traded self-storage REITs at the time were — CubeSmart, Public Storage (PSA 1.95%), Extra Space Storage, and Life Storage — saw a very short-lived drop in share price in 2008 before skyrocketing the following three years due to demand. These four REITs obliterated the annualized return of the S&P 500 during that same period.
• Communications and Data Centers: Salary cuts and job losses, among other economic impacts of a recession, often prompt people to curtail their spending when times are hard. This means less time and money is spent on extracurricular activities like dining out, going to the movies, or traveling, and instead more time is spent indoors doing more affordable or free activities. One thing that doesn’t fade is technological demand. Now unless you can buy land to lease out to infrastuture type businesses, REITs are a good way to invest in this area. For example, a company like American Tower (AMT90%) is a REIT, that, when it comes to recession resilience, offers exposure to both the communications and data center industries, which help store and aggregate data and connect people in our technological world. American Tower is the largest REIT in the U.S. by market capitalization, with 221,000 communications sites across the globe. Simply put, it’s massive. Communications infrastructure is its main bread and butter, with things like the adoption of 5G and its expansion into new markets helping drive its steady growth. But it’s also expanded into the data center space in 2021, acquiring the CoreSite data center REIT. Today, around 7% of its revenues comes from data centers, which is small in the scheme of things, but I see this number continuing to grow as the company further expands its presence in this space. Share prices are down 21% year to date, making it a great opportunity to snag shares in this high-quality company at a discount.
• Mobile Home Parks: Low Income housing is in great demand during inflationary time.  Mobile home parks have affordable housing, are limited in supply and traditionally perform well during inflationary and recessionary times.

Now, there are multiple REITs representing strong inflation-resistant type real estate investments but there are also other categories like note/deed/lien investing

Buy for the Long Term

As a final thought, it’s important to approach all of these as long-term investments. Real estate tends to do quite well over time, regardless of what inflation is doing. Remember to buy with the long term in mind.

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