While real estate values have increased over the past twenty years, in almost every other respect America has had the luxury of taking a three-decade vacation from the inflationary pressures that so preoccupied the concerns of our parents and grandparents. If anything, at various times economists and analysts have been more worried about deflation or disinflation than the opposite. Central bankers around the world have spent the years since the 2008 financial crisis trying to spark the economy into producing any inflation at all, much less the 2% annual figure the Federal Reserve and its global equivalents consider optimally healthy1.
1 For a sense of that alarm during the financial crisis, see Bart Hobjin and Colin Gardiner, The Breadth of Disinflation, FRBSF Economic Newsletter 2010-36, Federal Reserve Bank of San Francisco, Dec. 9, 2010.
The Return of Inflation
That all changed in the last two years, as a perfect storm of a pandemic-driven snarling of global production and shipping, unprecedented weather disruptions, lockdowns and border closures, trade tensions, shifts in consumer behavior, accelerated home buying and internal migration to desirable sunbelt cities all came together in a way that has clogged the wheels of the economy and pushed the official consumer price index inflation number to an annualized 5.4%1 in the fourth quarter of 2021.
These are some of the highest inflation numbers in decades. And many economists are warning this is a supply-shock phenomenon unlike any seen since the era of bell bottoms, wide lapels and the Ford Pinto. Like the 1970s, this period of inflation may be more long-lasting than might be expected. As Allison Shrager of the Manhattan Institute notes:
“We have reasons to believe that this moment is like the 1970s, when inflation averaged more than 5 percent annually and was so volatile that it topped 13 percent by 1980. First, last year’s recession was more of a supply shock than a demand shock. We shut down large swaths of the economy for many months. Unlike the 2008 recession, the 1974 recession also involved a supply shock, in the form of high oil prices resulting from the OPEC embargo, which caused shortages. This rippled across the economy, making goods more expensive, just as shortages on many goods do now2.”
Historically, periods of inflation leave investors in a quandary. Most financial investments struggle to keep pace with even modest inflation, much less periods of so-called “stagflation”, in which inflationary pressures are accompanied by sluggish economic growth. This is especially true of equities.
The stock market struggled throughout the inflationary 1970s. In a classic piece for Fortune Magazine in 1977, Warren Buffett outlined his views on inflation: “The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply consume capital. If you feel you can dance in and out of securities in a way that defeats the inflation tax, I would like to be your broker — but not your partner3.”
2 Allison Schrager, Is Inflation Here to Stay? City Journal, Manhattan Institute, Aug. 11, 2021.
3 Warren Buffett, How inflation swindles the equity investor. Fortune, May 1977.
How Using Financial Investments to Hedge Inflation is Inadequate
Many advisors today who have no memory of those times might suggest a rebalancing of portfolios towards fixed income assets. Unfortunately, the historical record shows bonds fare even worse than stocks during periods of inflation.
This is understandable. The rate of interest remains the same on most fixed income securities until maturity, so the purchasing power of the interest payments will decline as inflation rises. As a result, bond prices tend to fall when inflation is increasing.
Bonds generate fixed interest, or coupon payments. Rising inflation erodes the purchasing power of a bond’s future (fixed) coupon income, reducing the present value of its future fixed cash flows. Accelerating inflation is even more detrimental to longer-term bonds, given the cumulative impact of lower purchasing power for cash flows received far in the future.
Commodities, for their part, have also historically been seen as a hedge against inflation, and many financial advisors have discovered a new enthusiasm for them. It is definitely true that commodities should always comprise part of a well-managed portfolio, and they should do so for that very reason. But the innate volatility and unpredictability of commodities make them an unsteady partner through inflationary times. And they are not a long-term solution. While commodities are definitely a hedge against inflation, they do not provide a hedge indefinitely.
In fact, a famous study of the 1970-94 period undertaken in the 1990s by the Federal Reserve Bank of New York showed how relying on commodities to outpace and hedge against inflation is more fable than fact. The study likened commodities to the hare in Aesop’s “The Tortoise and the Hare,” as commodity prices are set in auction or flexi-price markets and therefore can sprint ahead quickly in response to actual or expected changes in supply or demand. By contrast, prices of most final goods and services, restrained by contractual arrangements and other frictions, respond slowly and steadily to supply and demand pressures, only gradually gaining ground on commodity prices.
Like the hare in the cherished fable, commodity prices tend to take a quick, early lead in inflation cycles but ultimately lose the race, falling in real terms over time to inflation’s steady tortoise.1
1 S. Brock Blomberg and Ethan Harris, The Commodity-Price Connection, FRBNY Economic Policy Review, Oct. 1995.
Real Estate as the Optimal Hedge against Inflation
As our parents and grandparents discovered in the inflationary 1970s, their best hedge against inflation was the house they lived in, primarily as its value likely strongly outpaced even the robust consumer price inflation of the era, as well as because their fixed-rate mortgages meant they were, in real terms, paying less all the time for their home the longer the inflationary period continued – and at an interest rate that undoubtedly was much lower than the ever-increasing 1970s and early 1980s rates.
Carefully designed real estate investment portfolios take advantage of our forebears’ wisdom to optimize this power. Using real estate investing as the ultimate hedge against inflation requires true expertise. As a recent study by the Man Institute of Quantitative Finance at Oxford University cites, “a targeted approach to property investment…delivers returns that are robust even in periods of inflation. Such an approach requires a granular and differentiated strategy that will take into account geography, type of tenure and economic backdrop. Not all property investment is the same and we believe that, if we are entering a period of higher inflation, investors in property will need to respond to this by being more discerning as to how and where they deploy capital.”1
Balco’s focus on the vibrant, rapidly growing markets of Austin and Miami reflects the strength of this approach. Unlike equities, bonds, and commodities, real estate price appreciation remains strongly robust across all of the real estate categories in which Ballard invests. Housing is famously skyrocketing in all three markets, as is industrial and warehousing-related commercial real estate. Perhaps surprisingly, the multi-family sector is also strongly procyclical, with high demand for rental properties outpacing some of the initial expectations of the post-pandemic recovery. Indeed, multi-family rents have risen by 10% over last year, according to Zillow, and a new study for the Federal Reserve Bank of Cleveland shows rental on newly signed leases are up by 17% over what the previous tenant paid.2
These multi-family rates are considerably higher in Balco’s three metro hubs. Between September 2020 and September 2021, rents have increased 24% in Austin and 20% in Miami 3. This is not what was expected as the beginning of the pandemic, when multi-family housing was expected to suffer as anecdotal evidence suggested people would flee apartments for the greater space of single-family housing, even if it meant leaving urban and suburban centers.
Some of this has in fact happened in less vibrant cities, but not in Balco’s target markets, where any intra-regional movement has been overwhelmingly replaced with new residents moving from other cities and states. The top three metro areas of origin for people moving to Austin are all in California: Los Angeles, San Jose and San Francisco.4 In Miami, they primarily move from New York, San Francisco and Chicago, as well as from within the state, especially Orlando. From December 2020 to January 2021, Miami saw an astonishing net migration gain of 145%, while the Silicon Valley-Bay Area region saw a loss of -47.2% in net migration.5
Good hedges against inflation should be sustainable by nature, provide yields that outpace inflation in a way that reflects “real economy” underpinnings, and should be stable enough to be a source of steady wealth creation. As the ultimate hedge against inflation, real estate investing hits all these marks.
1 Shabez Alibhai, Property as an Inflations Hedge, Man Institute Newsletter, Man Institute of Quantitative Finance at Oxford University, September 2021.
2 Cited in The Economist, Rental Resurgence, Oct. 16, 2021, p. 63.
3 Respective figures from KVUE-TV, Sep. 28, 2021; Commercial Observer, Sept. 1, 2021; Denver Post, Sept. 7, 2021.
4 KVUE-TV, Austin among top metros drawing new residents, new report finds., Apr. 21, 2021.
5 Ryan Carrigan, Is Miami the Next Silicon Valley? New Study Reveals Surprising Trends. Move Buddha Blog, Jul. 19, 2021.
6 Kyle Harris, Guess who’s coming to Denver? San Francisco and New York expats, for starters. Denverite, Oct 14, 2021.