4 Reasons to Own Real Estate During an Inflationary Period

4 Reasons to Own Real Estate During an Inflationary Period

 

You’ve read the headlines: “Highest Inflation since the 80’s,” “record inflation,” “inflation of 9%,” “high material costs,” “high employment costs,” “recession coming,” etc. Sounds like a horrible time to really do any type of investing. If you keep reading these headlines, you probably won’t do anything. You have to understand that the headlines are intended to get you to click a link or as we used to do – buy a newspaper. Yes, many of these articles are based on facts and analysis of what is going on right now, but inaction will cause you more financial setbacks in the long run.

 

We are big believers in investing in Real Estate because that is what we do. If you’re considering investing in Real Estate now this will help you understand the benefits of owning Real Estate. If you already own Real Estate – this will make you feel more confident in your investment. This article is intended to describe Investment Real Estate not primary residence residential real estate. There are still many benefits to owning a primary residence during an inflationary period, but those won’t be covered in this article.

There are very clear cost factors to consider when buying or owning real estate during an inflationary period such as rising interest rates, insurance, maintenance, material, and labor costs.

 

4 Reasons to Own Real Estate During an Inflationary Period:

1 – Appreciation. Have you seen what’s happened to Real Estate over the last couple of years? Property values have appreciated at record levels. Why did that happen? Well, the Covid pandemic unveiled many things going on in the economy. Construction levels have been relatively low for an extended period. The US hasn’t built new Real Estate at a higher rate since before the recession of 2008 – 2009. We had a crisis-level low supply in many areas of the country, Low Supply > Increase in Prices. When you combine that with a lot of people in the country making moves from larger population areas to more rural areas to evade the virus, you also had a redistribution of population and wealth that increased demand. High Demand > Increase in Prices. Both those factors at once created a massive spike in prices.

 

That’s all just recently too. Generally speaking beyond worldwide pandemics and all – Real Estate appreciates about 3% a year. Recently we’ve seen appreciation levels far beyond average in many markets. Now, as far as real estate investing goes – you have to factor in your objective with real estate. Are you buying and holding or trying to do a quick flip? Are you doing a lot of improvements and value-add or are you buying a turn-key property? The more improvements you can make both with the property itself and in business practices that will increase the Net Operating Income (NOI) will potentially allow for your property to see higher appreciation.

 

The Appreciation of your Real Estate is one of your main weapons to combat inflation. You’ll benefit from the market appreciation as a whole and your ability to ‘force appreciation’ by improving your property.

 

2 – Cash Flow Increases. A key advantage of Real Estate Investing is the owner’s ability to increase rental income to keep pace with rising costs. There is a degree of control that you have with making strategic decisions to manage a real estate asset unlike owning a stock or having a passive interest in other investments. There are multiple ways to maximize cash flow on investment properties both when a tenant is in a lease agreement and when a new vacancy arises.  The balance of supply and demand will set the market price for new vacancies. In a low supply environment of available real estate to lease, price is driven up. Many landlords actually look forward to vacancies because in high inflationary periods their lease amounts often fall behind the market – the vacancy allows them to match the market prices.

 

In Commerical Real Estate, the lease terms are often negotiated after an initial showing with a Letter of Intent. The Letter of Intent spells out how the landlord and tenant are going to pay different expenses and clarifies terms that will be formed in a Lease Agreement. One of the best ways a landlord can factor in future higher cash flow is to negotiate for escalation clauses and NNN (Triple Net) expenses. An escalation clause is spelled out in the letter of intent. If a tenant and landlord agree to a 5-year lease term, they may also agree to an escalation clause that states how much the lease amount due will increase annually by 3% for example. Another way to do this would be to tie the escalation clause to an inflation metric such as the Consumer Price Index (CPI). This is what the banks typically do when you get a Home Equity Line of Credit (HELOC) or Credit Card. The bank will state that your interest rate will be determined by a prime rate such as the Wall Street Journal Prime Rate + 2 Interest Rate Points. The escalation clause ensures increased rental income and if using the CPI index method, it will keep up with inflation.

 

A NNN Lease is the opposite of a Gross Lease. A Gross Lease means that the lease amount a tenant pays will cover all expenses – the landlord pays the utility expenses, taxes, insurance, maintenance, etc. Most residential lease agreements are Modified Gross lease agreements where the tenant pays utilities such as electricity, heating, and cable/internet and the landlord pays taxes, insurance, and often the water bill. A NNN Lease means that in addition to the lease amount due from the tenant, the tenant also pays the taxes, maintenance, and insurance for the building. Often times when you see a major chain restaurant or retail store, they do not own the building, but the owner has a NNN lease in place with that major chain paying most all of the major expenses.

 

3 – Tax Advantages 

Disclaimer: I’m not an accountant, everyone’s situations are different, talk to your accountant about how the below ideas apply to your property and your personal financial situation. 

There are many tax advantages to owning real estate. For now, we’ll focus on some core tax advantages: Operating expenses are deductible, capital gains can be deferred, and you can depreciate the real estate. This can all help out if you’re looking to minimize taxable income.

 

Operating Expense Deduction. After you collect rental income for the entire year, you factor that in as your Gross Income. But you don’t get taxed on that number – you have operating expenses such as maintenance, utility costs, insurance, mortgage interest, and repairs. After you subtract those items – that brings you to your Net Income. You are taxed on your Net Income, which should always be lesser than your Gross Income.

 

Capital Gains Taxes Deferred. This is a really important topic that we’ve written an entire blog on: Why You Should Consider a 1031 Exchange. Section 1031 of the IRS Tax Code allows you to defer capital gains on your investments as long as the capital gains are reinvested back into similar investments that are equal or greater in value. In this example, if you sell a $500k property and walk away with $250k of profit or proceeds after paying off your mortgage and closing costs, you can defer paying capital gains taxes on the appreciation of the real estate you purchased as long as you reinvest the proceeds into other real estate that is $500k in value or higher.

 

Depreciation. Didn’t I just write a whole section above on how Real Estate appreciates over time? Yes, yes I did, however, depreciation is a tax thing and tax things don’t always make sense. The IRS sees real estate as having a usable life that wears out, decays, and loses value. To offset the costs of buying and repairing real estate – the IRS allows you to depreciate real estate. Your accountant will set a depreciation schedule from the first year you own the property onward. They’ll start your ownership of the property with your basis, the amount you paid for the property.

Bonus Tip: Loans and debt are not taxable. Once you have enough equity in your property, you can do a Cash-Out Refinance where you take out cash from your property or secure a line of credit against your house with a Home Equity Line of Credit (HELOC – applicable to primary residence residential property) – that money is not taxable income.

  

4 – Time Value of money. Have you noticed how everything is getting more expensive? Food, houses, cars, electricity, taxes, everything! Well, this can work in your favor too. Look up the cost of bread or milk 30 years ago. buying real estate with a mortgage allows you to do the same thing through the financing cost of Amortization. Amortization allows you to take advantage of the time value of money and spread your interest cost over a longer period of time as opposed to paying it all at once. Inflation typically goes up an average of 3.5% per year, so that means everything get 3.5% more expensive each year – your One Dollar gets 3.5% less valuable. But that also means that if you can lock into a longer-term loan at a fixed interest rate – you can lock your mortgage payment at today’s value. 10, 20, 30 years from now – that dollar amount will be less expensive. As inflation continues to raise prices and devalue the dollar – you get to enjoy that lower payment when you factor in the time value of money.

 

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Krysten Reily

Krysten Reilly

Operations Manager

MFF Status: Morgan Franklin Fellowship Foundation

Business/Organization: Morgan Legacy Partners

About: Krysten Reilly serves as the Operations Manager with Morgan Legacy Partners. Before Krysten embarked in this career, she was working in hospitality management in New England, managing hotel and restaurant operations in Maine and Massachusetts. Krysten started her career in hospitality management first as the Assistant Food & Beverage Manager of a hotel restaurant but then quickly rose through the ranks to become the General Manager of two hotels within the same hotel group’s portfolio. Krysten holds a Bachelor of Fine Arts and a Master of Science from Syracuse University. Krysten lives in Charlotte, North Carolina, where she serves as Morgan Legacy Partner’s Carolinas representative.

Specialties: Hospitality and Operations Management, Events Management, Revenue Management, Runner, Snowboarder, Hiker, Outdoor Enthusiast