There is a lot of talk about inflation vs deflation, interest rate hikes in 2022, and what the general market conditions will look like in 2022. Given that real estate in general is a leveraged investment these are topics we are keeping a close eye on. The Jury is still out on whether we are experiencing true inflation vs transitory inflation, but as real estate investors I think it is important to understand both inflationary, and deflationary trends and how each affect real estate investment.
Both inflation and deflation in moderation are a normal part of the economic cycle. These trends can be tied to both the debt cycle as well as supply and demand forces. This is where the argument of transitory vs lasting inflation starts, but first let’s take a moment to define inflation.
Inflation is a lasting trend of increasing prices for goods and services caused by an increase in the supply of money. Inflation devalues a currency and erodes the purchasing power of a currency. The case for “transitory” or temporary inflation is made by the claim that the increased price of goods and services is caused not by an increase in the money supply, but by supply shock.
It’s no secret that global supply chains are being strained by demand, as industries worldwide are ramping up post covid-19 shutdowns. The imbalance of supply and demand naturally causes prices to rise, but given that we are experiencing both an increase in the money supply and supply constraints, economists are at odds with each other as to whether we are to expect lasting inflation or if the current historic rise in prices is just temporary.
There is also a case to be made that we are just as likely to experience deflation in the near future, which is characterized by an overall weakening economy and a decrease in the cost of goods and services.
Deflation can be caused by weakening demand, oversupply, or a decrease in the supply and velocity of money, and as counterintuitive as it may seem, extreme inflation can actually lead to deflation. This can happen when continuing increases in the cost of goods and services inevitably lead to lower net profits for businesses, as businesses experience ever higher costs to restock inventory.
Both inflation and deflation are a normal part of the economic cycle and in moderation are tolerable. Extreme inflation or deflation is much less tolerable and can have dire economic consequences.
As economists debate whether we are experiencing transitory inflation, true inflation, or headed into a period of deflation, we are all asking the question, “What is next?”. I don’t think anyone can say for certain, but I myself believe we are likely to experience both inflationary and deflationary forces over the next few years. The scale of these forces and the subsequent economic impacts are still unknown.
There is a silver lining in all of this. Multifamily real estate, in general, has the ability to perform in both an inflationary and a deflationary environment.
In an inflationary environment it is one of the few assets that can effectively hedge against inflation, and the consistent cash flow provides a much needed additional sources of revenue as the value of the currency declines. Multifamily real estate also experiences significant appreciation as the value of debt is eroded by paying down the debt with currency that is worth less than the currency you borrowed to purchase the asset.
In a deflationary environment the consistent cashflow again provides a much needed additional stream of revenue at a time when wages are falling. Back in 2008 when real estate was taking a beating during the financial crisis, multifamily real estate had one of the lowest default rates of all real estate asset classes. This was driven by the fact that multifamily occupancy tends to outperform in markets where wages are declining and unemployment is rising.
This leads to many people becoming renters or choosing to continue renting as it becomes difficult to secure financing for home purchases, and many families are forced to downsize as wages no longer support their mortgage payments.
There is a reason that so many ultra wealthy investors anchor their portfolios with multifamily real estate assets. These assets, when purchased in the right markets, and combined with a great business plan and an experienced team who can execute the business plan, can perform in any economic environment.