Rising Inflation; Inflationary hedges, and the future of real estate investing

Inflation rates in the Eurozone came in at 4.1% this October; compared to 4.6% in Germany and a whopping 5.4% in the US — the highest numbers since September of 2008. For reference, the European Central Bank targets an inflation rate of 2%. Essentially, these figures tell us we are losing purchasing power at an alarming rate, but what can be done? — Author: Francisca Ducos

Image 1: Euro-area annual inflation and its main components (%)

What is inflation?

According to the European Central Bank, inflation “occurs if there is a broad increase in the prices of goods and services”. What this means is that inflation reduces the value of a currency, and with that our purchasing power, over time. You can afford less for €1 today than you could yesterday.

The most common way of measuring inflation is through Consumer Price Index (CPI); this is defined as the change in the prices of a basket of goods and services that are typically purchased by households. You can imagine this ‘basket of goods’ as containing everyday items and services that every person needs, such as cereal, milk, coffee, utilities, etc. The inflationary value and CPI value are analogous.

Why does inflation exist?

Inflation cannot be exclusively attributed to any one single cause, and furthermore, factors may have different influences in different countries and economic areas. Nevertheless, it is often agreed upon that a certain base level of inflation is desirable.

The idea is that a steady increase in prices over time keeps the economy running at, or near, capacity. Without it, we risk the feared deflation; prices start decreasing. Deflation is extremely dangerous for an economy because consumers stop spending entirely in anticipation of further falling prices. This may lead to decreased production, layoffs and ultimately economic — and in theory social — turmoil.

As inflation is currently very (if not overly) present, the rising prices make it all the more important for us and investors to develop a robust and diversified portfolio containing sufficient and effective inflation-hedged assets.

Hedging against inflation

Inflation hedging aims to protect (i.e. hedge) an investor’s funds from being devalued over time through strategic investments. There are myriad ways to hedge against inflation, some common means include stocks, bonds, commodities like gold, and real estate. Each has its advantages and disadvantages, but the consensus is to spread risk by opting for several hedges.

Naturally, different asset classes have different hedging potentials, and no asset hedges inflation perfectly. Nevertheless, what these hedging potentials are is invaluable information for any investor wishing to strategically allocate their assets. For example, empirical findings show that stocks hedge low inflation poorly, but perform well in high inflation, while the reverse can be said to be true of bills and bonds.

Furthermore, contrary to the popular belief that gold is a “safe haven” in times of financial uncertainty, it — like most commodities — can be quite inconsistent and volatile as an inflationary hedge; this is because the value of commodities hinges on supply and demand, which can drastically be affected by numerous factors, ranging from natural disasters to geopolitics. As a result, commodities trading warrants caution and significant expertise.

When it comes to hedging against inflation, one type of asset reigns supreme: real estate. This asset class displays robust protective features against inflation, particularly because real estate returns are two-fold: rental income and capital appreciation. Moreover, nominal rents can be expected to be responsive to inflation, meaning that they will rise accordingly and thus ‘buffer’ against the depreciation of the currency. On the other hand, capital value is closely linked to both rental level and capitalization rate. As a result, the increase in capital value of real estate can reasonably be expected to stay on par with inflation levels.

Overall, it can be said that real estate is a “long-lived asset with income that adjusts to inflation”. Beyond economic considerations, past experience shows that in times of financial crisis, investors flock to and heavily rely on real estate.

Investing in real estate

There are many ways to invest in real estate. The most traditional method consists of buying a property, holding, and selling it for a profit. Investors will also often rent out the property in order to cover costs.

There is nothing inherently wrong with the traditional methods, however, there are some cumbersome issues. Firstly, purchasing real estate has large capital requirements; this already presents a seemingly insurmountable obstacle for many. Next, an investor has to deal with hefty notary fees and property taxes. Ultimately, when the property is owned, it requires management and regular maintenance; a cost, time, and effort-intensive duty.

Holding real estate assets in a traditional manner also implies illiquidity, as investors will not be able to easily or immediately sell their property in exchange for cash. All of these factors may present themselves as deterrents to those interested in acquiring real estate as a hedge against inflation.

A more modern way to invest in high-quality real estate?

Modern proptech (property technology) investment startups recognize the prohibitive elements that come with investing in real estate. It becomes particularly interesting when their mission deals with the democratization of real-estate investing through fractional equity ownership.

About capneo

capneo stands for fractional equity ownership of real estate investments.

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Author

Francisca Ducos is a research lead for Blockchain Founders Group (BFG). She studies European Law at Maastricht University, and is currently working on projects dealing with NFTs and blockchain, focusing on their relationships with the law. You can contact her via email.

References

1. Image 1: https://ec.europa.eu/eurostat/statistics-explained/index.php?title=Inflation_in_the_euro_area
2. https://www.cnbc.com/2021/10/01/euro-zone-inflation-hits-highest-level-in-13-years-as-energy-prices-soar.html
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4. https:s://www.reuters.co//tradingeconomics.com/united-states/inflation-cpi
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6. https://www.ecb.europa.eu/ecb/educational/hicp/html/index.en.html
7. https://www.investopedia.com/ask/answers/111414/how-can-inflation-be-good-economy.asp
8. https://d-nb.info/1031514961/34
9. https://d-nb.info/1031514961/34
10. https://www.investopedia.com/articles/investing/081315/9-top-assets-protection-against-inflation.asp#2-commodities
11. Hoesli, M., Lizieri, C. and MacGregor, B. (2007) The Ination Hedging Characteristics of US and UK Investments: A Multi-Factor Error Correction Approach,
12. https://realestate.wharton.upenn.edu/wp-content/uploads/2017/03/716.pdf