Everyone knows that real estate is a great hedge for inflation.
Any time I hear that “everyone knows” anything, I immediately question the statement. Our collective wisdom and “common sense” is prone to major blind spots. So when I have the data to test such common knowledge, I do so.
The conventional wisdom explaining why real estate is an inflationary hedge goes something like this: as inflation increases, the value of properties is supposed to increase along with the amount charged for rent.
The graph below was compiled using data from the Bureau of Labor statistics and a national property price index (United States). The plot points represent year-on-year inflation (x-axis) and property price appreciation (y-axis) measured quarterly from the end of 1978 through Q3 2016.
What does the data tell us? There’s very little correlation between inflation and real estate property appreciation. The correlation for all the data is fairly weak at less than 0.4.
However, something curious happens during periods of high inflation: the correlation increases to almost 0.9.
Real estate is a fantastic hedge for inflation when inflation is high.
During periods of low inflation and deflation like we’ve experienced for over three decades, the data is hardly convincing. The rabbit hole gets deeper…different types of real estate behave differently in relation to inflation. The best inflation hedges to the worst are as follows:
- Multifamily Apartments
Notice that “single-family house” is noticeably absent. When I plotted the price appreciation of houses, there was no discernible relationship to inflation.
The health of the underlying property markets matters a lot to the relationship with inflation. If physical construction costs, labor costs, and land are all expensive, owners of already existing property are protected from rising prices. They already have a building, but the profit of potential competition is continuously being squeezed. That new apartment building has to charge much more for the same quality of property to make the same margins as the older building.
The relationship between property appreciation and inflation generally increases as the value of the property does. Basically, that inflation hedge is mostly only available to institutional investors or Ultra High Net Worth individuals.
How does this information help you, how is this even remotely relevant to you?
When you make the decision to invest or not invest in real estate, take the “fact” that it’s a hedge against inflation off of the table unless you’re in the position to comfortably own and rent out an apartment building. Invest in the asset because of the cash flows it will provide and the potential increase in value that you can add.
Think of your home that you live in as a forced savings program that could lose money as equally likely as it could make you money. Don’t count on price appreciation to make it a great investment. Don’t count on it to protect you against inflation, because it won’t.