Inflation and Rental Income

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In this article, you will learn why real estate is one of the best hedges against the ravages of inflation.

The Impact of Inflation

Before I get into why real estate is an excellent hedge against inflation, I want to talk about the value of money. Money in and of itself is of no value. The value of money comes from the goods and services you can buy with money. Inflation is the declining amount of goods and services the same amount of money will buy over time. Below is a chart showing how much money it would require today to buy the same basket of goods you bought in 1990 for $50.

To buy the same basket of goods today that you purchased for $50 in 1990, you will have to spend more than $100. You can either view this as prices are increasing or that the buying power of the US dollar is declining. Either way, your income must increase at or above the inflation rate, or you will have to reduce your standard of living.

How does inflation impact rental income? Suppose you rented a property for $500/Mo. in 1990. Today, the rent would have to be more than $1000/Mo. for you to be able to buy the same quantity of goods and services you did for $500 in 1990. Despite receiving more money per month, there was no actual increase in inflation-adjusted buying power; your buying power stayed the same.

The point is that just having the rent increase is not sufficient. Only if the rent increases faster than the inflation rate is your ability to buy goods and services increasing. Otherwise, it is staying flat or decreasing.

A Tale of Two Markets

Understanding how inflation impacts your rental income is essential. To underscore the point, I will compare two identical properties in two different cities. In the first city (City 1), rents are increasing by 3% annually. In the second city (City 2), rents are increasing by 9% annually. See the chart below.

Note: to keep the following example simple, I ignored the effects of inflation on costs like taxes, insurance, maintenance, etc.

If you ignore inflation, rent growth looks good in both cities. But, what is happening to the buying power if there is inflation? Below I assumed a 5% rate of inflation.

Because City 1 has an appreciation rate below the inflation rate, the inflation-adjusted income declined to $735/Mo., a 27% decline. This is the problem with investing in any market where rents are not increasing above the rate of inflation. If you look at City 2, over the same period, the inflation adjusted income increased by 62%.

Note that while rental data for different markets is not always easy to obtain, you can usually find historical sales price information. This is an excellent indicator of what rents are links to do in the future. The reason is that rents track prices, but with a 2 to 10-year lag depending on the specific market. So, the price trends you see today are an excellent indicator of how rents will trend in the future. So, if housing prices are not rising faster than the inflation rate, rents will not either. Also, when looking at market price trends, ignore the last 12 months, with its COVID-induced price frenzy.

So, choosing an investment location based only on initial ROI is a mistake. ROI is a snapshot in time. ROI (and similar metrics) only predicts how a property will perform on day one of a lifetime hold. How a location will perform over the next 10 to 20 years is far more important than how a property performs on day one.

Inflation and Rental Income

Historically, rent tracks inflation. So, the higher the rate of inflation, the more rapidly the rent increases. And, since your major cost is fixed (debt service), the rate of return will increase. However, unless rents increase at a higher rate than inflation, you will still lose buying power over time.

In Conclusion

If your rental income is increasing above the inflation rate, inflation is advantageous. However, even if the rate of increase is below the inflation rate, real estate is still the best hedge against inflation.