Milton Friedman stated that inflation was “always and everywhere a monetary phenomenon.” In other words, he thought all roads lead to inflation when central banks printed money. About 40 years ago, the Nobel Prize-winning economist compared inflation to alcoholism. Like drinking alcohol, Friedman argued that, initially it felt euphoric when these entities began to print money. However, he believed that there was a strong temptation to overindulge, and, if too much money was printed, or, similarly, if you were to drink too much alcohol, then ill effects would follow.
The world has changed considerably since Friedman made this comparison in 1980. At the time, inflation was running hot and noted fiscal hawk Paul Volker was appointed chairman of the Federal Reserve. Through a series of aggressive interest rate hikes, Volker slayed inflation. It peaked at a little over 14 percent when Volker assumed control at the Fed. While his rate hikes pushed the economy into a recession, he ultimately won the war against rising prices. Inflation dropped to less than five percent by 1989 and ushered in decade-long economic expansion.
There are many different types of inflation and not all inflationary conditions produce bad outcomes. This is particularly true from our perspective at Origin Investments as commercial real estate investors. Clearly, certain inflationary environments could hamper our investment returns, but other situations can help, and the degree of inflation matters as well. This is why we subscribe to a nuanced definition of inflation. You can better understand our perspectives on the causes of inflation and the impact on real estate returns if you think in terms of demand-pull and cost-push inflation.
A Different Problem for the Fed
In stark contrast to Friedman and Volker’s world, current Fed chairman Jerome Powell faces the opposite problem: despite his best efforts, he is struggling to create inflation. Under Powell’s leadership, the Fed recently announced in August 2020 that it was updating its thinking toward inflation. The central bank formally agreed to a policy of “average inflation targeting.” Up until that point, the Fed had set a target of achieving two percent annual inflation. Under this new policy, the Fed will allow inflation to run above two percent. Practically speaking, this means the Fed won’t necessarily increase interest rates when unemployment decreases.
Regarding this significant change in policy, Powell said, “Many find it counterintuitive that the Fed would want to push up inflation. However, inflation that is persistently too low can pose serious risks to the economy.” In the wake of the Fed’s change to inflation policy, we have heard a wide range of views from investors and economists. Some think that inflation will remain benign in both the long-term due primarily to advances in technology and in the short-term because of the pandemic, among other reasons. Others point to spiraling government deficits, unprecedented stimulus, and near-zero interest rates as proof that inflation is about to spike. The truth is probably somewhere in between these extreme points of view. But what does the data say?
The Personal Consumption Expenditures (PCE) Index is one of the Fed’s favored measures of inflation. The PCE measures prices for goods and services in the U.S. and it is known to capture trends in prices across a wide range of expenses. The following chart reflects the PCE Index changes since 1959.
The chart is reminiscent of the famous Will Rogers quote: “Invest in inflation. It’s the only thing going up.” Rogers’ sentiment is captured in the above chart and you might even find wisdom in his quote. But the chart does not quite capture some of the nuance in inflation over the past 60 years, particularly the spike in the 1970s and the lull over the last decade.
This next chart contemplates the same data series; however, it plots the one-year change. On this chart, it’s much easier to see the spike in prices during the 1970s due to easy money policies and skyrocketing oil prices, Volker’s countermeasures taking hold in the 1980s, and what some at the Fed call “stubbornly low inflation” since the financial crisis in 2009.
During the last ten years, the PCE has been at or below the Fed’s target of two percent which is the “… persistently too low…” metric that Powell refers. While the PCE temporarily spiked over the last decade to about 2.5 percent, the average inflation rate over the last ten years has been around 1.8 percent. During the financial crisis in 2009 the inflation rate even dropped into negative territory and again to zero in 2015 after crude oil prices crashed. More recently, the very far right edge of the chart reflects another dip early in 2020 triggered by the COVID-19 pandemic.
Should you Fight the Fed?
Armed with historical context on inflation and understanding the current directive for Fed policy, the adage of “don’t fight the Fed” comes to mind. This axiom applies to making investment decisions based on whether the Fed is attempting to raise or lower interest rates. History is not conclusive in that investors are rewarded to align with the Fed and invest when the Fed is cutting rates and not investing when they are raising rates.
This adage becomes even more challenging to unpack when inflation is included in the equation. Should you fight the Fed by dismissing what they have said concerning their modern battle against low inflation?
We think you can win the battle to outpace inflation and protect your purchasing power by investing in multifamily real estate and not fighting the Fed at all.
How to Hedge Against Inflation
Unlike bonds and cash, which lose purchasing power when prices for goods and services are rising, commercial real estate is generally a fantastic hedge against inflation because it holds intrinsic value, is in limited supply and is a yielding asset.
At Origin Investments we view multifamily as one of the best inflation hedges within commercial real estate because lease structures in multifamily are far better positioned to benefit from an increase in inflation than other asset types. Other commercial real estate assets might have lease durations of five, seven, or even ten years, but multifamily leases can reset at six, nine, or 12 months. And when these leases reset, it gives us an opportunity to reprice rents as prices increase.
The annual turnover of an entire multifamily property is usually around 100 percent. This high frequency provides investors the opportunity to quickly react, increase rental rates, and hedge against rising inflation should the Fed’s policies produce the intended results. Further, we engineer even more flexibility in our multifamily properties by staggering lease expirations through the peak spring and summer rental periods, which is when you can typically maximize rental rates over the course of the year.
At the most basic level, it is essential to remember that multifamily real estate is a necessity-based asset. While it is an investible asset, the primary purpose is to provide shelter and there is tremendous friction (cost, effort, and time) for people to move. As a very active investment manager, we strive to create a culture in our communities where our residents have a personal connection with their neighbors and the property staff, which creates additional friction on the desire to move. Therefore, the primary substitute to one of our multifamily communities is buying a home; however, the circularity of rising rental prices due to inflation creates additional friction via increases in home prices.
It is right to question the conventional thinking surrounding single family homes as a substitute for multifamily due to the profound shifts in demographics and consumer preferences. Baby Boomers are downsizing, freeing up cash, and avoiding taking on new mortgage liabilities in the current chapter of their lives. Unlike their Boomer parents before them, Millennials are forming households far later and are still scarred from the Financial Crisis. Gen Z is just entering the workforce and their savings rate is at historic lows and will struggle to amass savings for a down payment for a home purchase.
Regardless of inflation, these trends are a tremendous tailwind to multifamily real estate. Beyond the impressive demand by prospective renters, there are many more benefits to this asset class that one might be missing.
There is one final layer of protection that we are embedding in our approach to multifamily real estate investing as an inflation hedge – the locations of our assets.
The Sun is Shining on the Suburbs
Our strategy at Origin is to target suburban locations in high-growth markets, particularly in the Sun Belt. Millennials are migrating to the suburbs in massive numbers and here’s why:
- – Suburban schools are typically higher performing.
- – Suburban communities are knit a bit tighter compared to urban counterparts.
- – The quality of life, defined by crime rates, traffic, privacy, and access to open spaces and nature, is generally superior.
- – Cities have a higher cost of living than the suburbs.
- – You can have a greater impact on your community vis-à-vis local government in small communities than large cities.
The reverse migration trend driving people from cities back to the suburbs has been unfolding for years and the COVID-19 pandemic only served to accelerate this shift. These observable demand trends are likely to produce strong investor returns even if inflation remains subdued and interest rates low.
At Origin Investments, we are proactively positioning to protect the wealth of our investors against, and possibly even benefit from, a moderate amount of inflation. While we do not endorse Milton Friedman’s comparison of inflation to alcoholism, like with most things in life, moderation is key. A small amount of inflation is nothing to fear, especially if you have investments in multifamily real estate. A moderate uptick in inflation might even improve your overall investment returns with exposure to the multifamily sector.