What Is an Inflation Hedge?

Inflation was a huge factor in U.S. economics in 2021.

The year started fine – inflation was just 1.4 percent in January, but by November it had skyrocketed to 6.8 percent, the highest U.S. inflation rate since 1982.¹ That upward trend was keenly felt in American pocketbooks through higher costs in energy, gasoline, food, lodging, vehicles, apparel, and a host of other core commodities and professional services.

Investors have long used hedging as a means to manage risk and shelter or protect a portion of their finances from volatility caused by inflation. There are a number of investments that can provide an important hedge against inflation. In this article we’ll take a closer look at inflation hedging and how it pertains to real estate investors.

Inflation Hedge Strategies and Why They are Important

Investment hedging strategies seek to minimize or offset investment losses by taking varying positions across a range of assets and investments to potentially reduce or mitigate the negative financial impacts of losses in any one sector. Think of it like buying insurance on your vehicles – you’re paying your agent for asset and personal protection. In the event of a crash, your policy limits your financial liability.

Hedging in public financial markets usually takes the form of investing in assets that run counter to your primary investment focus with the goal of trying to manage potential losses in bear markets. In order to properly hedge financial markets, investors rely on readily available market pricing of upwards and downward movements in order to take opposing positions to their core investments. 

These data are not available to investors seeking to protect their position, reduce exposure to certain markets or asset classes, and stabilize portfolio performance by hedging their real estate investments. Investors can use transaction-based and appraisal-based indices to help them gauge average sale prices and performance metrics for commercial real estate. However, even these tools can prove fallible since many types of commercial properties sell infrequently in transactions that are out of the public eye.²

Hedging Strategies in Real Estate

There are many ways real estate can act as a hedge against inflation. 

Take your home mortgage. You’ve likely seen significant asset appreciation over the past five to 10 years. That boost in asset equity acts like a hedge by lowering your loan-to-value mortgage debt.

Multi-family investors have multiple ways to use these assets as a hedge against inflation. Multi-family property values have increased substantially since the Great Recession, and the runup in single-family home prices has strained multi-family vacancy rates in primary and tertiary markets across the U.S. This pressure has led to increased rental rates, which is predicted to remain strong throughout 2022.³ Multi-family landlords can adjust rents upwards when renewing or issuing new leases to meet changing market conditions caused by inflation, which can hedge their multi-family investment dollars.

Another hedging strategy in real estate is to use asset equity to refinance investment properties and use excess cash for diversified investments that likely won’t be impacted by inflation or falling real estate prices. This strategy can increase your overall debt and raise your risk profile, however. 

The Bottom Line

Real estate can be difficult to hedge because it’s highly illiquid during recessionary times, and asset values can be volatile. Investors can hedge their real property investments in a number of ways, from simply holding the investment to realizing increased rental growth caused by inflation to depreciating debt as the asset appreciates. Landlords can use periods of high inflation to renegotiate leases that take into account upward mobility in the Consumer Price Index, as well as adjust their portfolios in an effort to diversify their real estate holdings by market segment and asset class.

Sources:

1. United States Inflation Rate, Trading Economics, https://tradingeconomics.com/united-states/inflation-cpi

2. What are Transaction-Based Indices, CFI, https://corporatefinanceinstitute.com/resources/knowledge/valuation/transaction-based-indices/

3. 2021 Multifamily Market Mid-Year Outlook, Fannie Mae, https://multifamily.fanniemae.com/news-insights/multifamily-market-commentary/2021-multifamily-market-mid-year-outlook-demand

 

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. All investments have an inherent level of risk. The value of your investment will fluctuate with the value of the underlying investments. You could receive back less than you initially invested and there is no guarantee that you will receive any income.All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure. Diversification does not guarantee a profit or protect against a loss in a declining market.  It is a method used to help manage investment risk.

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