The Best Way To Hedge Your Investments Against Inflation - Real Estate Investing!
When investing in real estate, your investment gives you a hard asset, real and tangible. Hard assets have a unique ability to hedge against inflation and real estate is even more unique than other hard assets because it has the ability to generate cash flow.
Understanding Inflation
There are two main drivers of inflation: economic growth and monetary debasement. Both of these have been hot topics in the media this past year as we look to economic recovery from CoVID 19 and they cause significant worry to investors looking to maintain their portfolio value.
(1) Economic Growth
When an economy grows rapidly, prices for goods and services increase. Inflation generally increases when the GDP is above 2.5%. When demand is greater than supply, prices begin to increase and consumers spend more to get the same product. Manufacturers increase their production to meet demand by hiring more people. As the supply of labour decreases, wages increase further increasing the costs of these products. Higher demand for products increases GDP and the resulting higher costs of the products results in increased inflation.
Historical GDP - Canada
(2) Monetary Debasement
When a country prints more money, it makes the value of the currency lower and therefore lowers the purchase power of the currency. There is more money printed but not a correlating level of output which results in inflation. In Canada, the Consumer Price Index measures the change in price people pay for a basket of goods.
Historical Consumer Price Index
How Does this Apply?
The general predictions were that 2021 would ease towards the central banks’ target of 2%. According to the TD Bank in their article Canadian Inflation in a Post Pandemic World, “a large chunk of the decline was led by gasoline and fuel prices”. However, we have now see a big recovery in oil from the beginning of 2021 which will increase inflation. The article continues to say that “changes in consumer spending patterns mean that the reported inflation rate, which is based on fixed expenditure weights from 2017, may no longer be representative. This was also reported by CBC in their article Inflation number really are being distorted by COVID-19 spending, new research shows and says “the pandemic has altered the selection of the things people buy while the official “basket” of goods and services has not shifted”.
So what does all of this mean? In 2020 a lot of our economy was shut down (driving down demand) but the government printed billions of dollars to help Canadians through the pandemic and keep the Canadian economy from crashing. As we have seen in the second half of 2020 as economies began to re-open there was a surge for products and services. A combination of both of these increases the costs of products and services as we reviewed above in the two main drivers of inflation.
Many Canadians are seeing higher costs for basic needs like food but these costs were offset in 2020 (relative to the Consumer Price Index) while spending much less on fuel and transportation that are typically measured for inflation. There is concern from many economists and investors that inflation is being under reported because the costs of goods and services people are actually using are now using are increasing more than what is being reported.
According to the article Alert: Inflation Could Surge in 2021 by Motley Fool, “if inflation continues to rise you should expect the stock market to dive lower…. Assets such as gold and real estate are considered traditional inflation hedges.”
The Benefits of Hard Assets during Periods of Higher Inflation
Hard assets hold an intrinsic value in that they are a physical asset and not paper or virtual. Assets with intrinsic value such as real estate, gold, silver, oil, etc. are naturally in limited supply, you just can’t print them out of thin air and they can be used to buy needed goods and services or traded in return for goods and services. It is this intrinsic value held by hard assets that make them good to hedge against inflation. As well, when you buy real estate, you essentially have two hard assets, the land and the structure because they both are in limited supply and they both serve basic human needs.
Stocks and bonds are examples of “soft assets”. It is harder to maintain your investment dollars with inflation because they will usually lose value as the Consumer Price Index increases. The Canadian Consumer Price Index measures the changes in price people pay for a basket of goods, as the value of money decreases, the cost of goods increases. Generally speaking, with hard assets, as the price of a basket of goods increases, hard assets usually increase in value on the same trajectory.
Land and Building Structures
We all know that there is only so much land in the world and therefore it is naturally limited. Each piece of land also does not hold the same value because of basic economics, depending on the location of the land the demand for land can increase that value as the supply is low. That is why an acre of land in downtown Vancouver is valued higher than an acre of land in northern Newfoundland.
The building structures are composed of raw materials, in times of high inflation, the cost for those raw materials increase. As the price to build a similar structure increase, the value of the structure also increases.
For these reasons, real estate often has its value increase with inflation making it a strong portfolio diversification asset.
Real Estate Investment
Real estate is one of the strongest investments with or without high inflation. The real estate market out performs other investments and it does this with less volatility. A stock can drop to zero in a short period of time, real estate does not have this risk.
There are 6 ways real estate delivers as an investment (for more details, see our YouTube video– Why Real Estate Investing - Part I)
(1) Cash flow: the amount of money left over from monthly rental income after all expenses are paid.
(2) Appreciation: the amount the property will increase over time.
(3) Loan Pay Down: the amount of the mortgage loan paid down by renters.
(4) Forced Appreciation: increase the value of the property through improvements.
(5) Leverage: ability to leverage money from the lender rather than an investment fully funded with your own capital.
(6) Tax Advantages: through consultation with your accountant, you may have the ability to defer taxes
(7) Tangible: As we discussed here in this article, hard assets have an intrinsic value that is not as susceptible to economic changes.
Historically, it is proven that real estate will always increase over time. To see how investing in real estate compares to investing in the stock market with a real example see our video Why Invest in Real Estate - Part II
To learn more about real estate investment and how you can diversify your investment portfolio, go to Contact Us to set up a free consultation and also sign up for our weekly newsletter.