David is the Founder and CEO of Realized, a firm whose mission is to improve lives through innovative investment property wealth solutions.
When it comes to inflation, most investors may think it’s a cause for concern, but as discussed on a recent podcast from IREI, what they actually care about is the effect inflation has on their portfolio, not the effect inflation has on the market itself.
Inflation, generally speaking, impacts the cost of a basket of goods as a whole. I believe that most investors don’t actually care about the impact of inflation on the entire basket of goods, but instead the changes in relative prices and values for the items in their individual investment portfolios. They are seeking investments that have the potential to outperform inflation to preserve their purchasing power.
The Current Outlook On Inflation
There’s speculation in the market as to whether the current period of inflation is here to stay or if it’s only temporary. While many are concerned about the rising levels of inflation coming out of the depressed market in 2020, the Federal Reserve recently predicted that this period of inflation is transitory and isn’t here to stay. This transitory inflation is said to be a result of pent-up demand and supply change issues and is not predicted to look like the long-term, runaway inflation that occurred in the 1970s. The Fed has more tools (monetary and fiscal policies) at its disposal than it did in the past, giving it more control than in previous decades.
However, despite having more tools and control, the Fed cannot perfectly control inflation. For example, the 10-year treasury, which is not controlled by the Fed but rather the market, is still at historic lows, yet the cost of labor and materials prices is rising quickly and leading to concerns about a “wage-price spiral” after coming off a multi-decade decline in real (inflation-adjusted) wages. In addition, the Fed is no longer seeking deflation and is focused more on implementing inflationary policy than any administration in recent history. This leads experts to believe that inflation is coming even if it is not runaway inflation as seen in previous decades.
Affect On Your Portfolio
For investors curious about what inflation may mean for their investment returns, decreasing interest rates have led to rising values via higher equity multiples (for stocks), lower yield/higher valuation for fixed income and lower cap rates for investment real estate.
In addition, when it comes to managing risk, investors have historically relied on a low correlation between stocks and bonds to manage overall risk in a portfolio. But, will this historic relationship hold true in an environment with meaningful inflation? I believe so, but it’s been about 40 years since we’ve been in such an environment.
Considerations For Right Now
For investors curious as to what they can do now in an effort to curb the impact of inflation, core real assets (real estate, infrastructure and transportation) are good to consider according to Jared Gross, managing director and head of institutional portfolio strategy at J.P. Morgan. “Core” refers to assets that are essentially fully valued and high-quality operating assets. They have the potential to provide more steady returns and increase total returns from current income. They also have a low correlation to equities (helping to manage overall portfolio risk).
Like other core assets, real estate has historically been resilient to inflation. Real estate specifically can offer returns from two components: income and appreciation from the asset. The income from real estate can be higher than the equities market (related to real estate cash flow versus dividend distribution). Real estate can also provide the ability to lock in longer-term, fixed-rate financing — potentially providing a boost to appreciation upon investment exit — as well as be an income tax shelter to further enhance after-tax income.
Direct Real Estate
When it comes to investing in direct real estate, I believe that too much wealth is trapped in legacy properties. Direct real estate has the potential to provide additional income streams and build wealth across generations, but there are considerations with these types of investments. With direct property ownership, investors may be burdened by the three Ts of property ownership: tenants, trash and toilets. When a tenant moves out, there is the potential for lost revenue if the property sits vacant. What happens when there are maintenance issues? Plus, there may be a large tax bill at the sale of the direct property if an investor doesn’t consider an exit strategy. In order to mitigate and avoid some of these issues, I recommend sticking to certain principles for investing, including using a 1031 exchange to defer taxes when selling property and investing any proceeds into a portfolio of diversified commercial real estate properties.
But while this may be an appealing avenue for the average investor, the size and scale of some investments may prevent individual investors from accessing core assets. A single investor may not be able to directly acquire, say, an Amazon warehouse or invest in a public REIT. However, fractional investments are an option that can provide you with investment opportunities in real estate and are 1031 exchange eligible, helping investors with both a way to manage inflation and a tax-deferred investment strategy. I recommend looking into fractional investments in commercial real estate properties through something like an unincorporated business trust, which can provide investors with core real estate investment opportunities that are designed to provide tax benefits.
The Bottom Line
Ultimately, I believe that one of the best ways investors can manage risk and inflation and maximize potential returns is by creating a diversified portfolio that includes different asset types with low correlation to each other. This can allow investors to create tax-deferred earnings. As a part of their portfolio, core investments like real estate can provide the alternative investment type investors need to further diversify while also helping to provide a hedge against the current inflation in the market.
Full disclosure. The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.