The COVID pandemic has caused unprecedented economic and emotional destruction. Lives and livelihoods have been lost all across the globe with many of the livelihood losses permanent. We hope that mass vaccinations campaigns underway in the US will go a long way in terms of building herd immunity and finally bringing an end of the biological crisis. Albeit, there is another crisis whose end is not so near and one which may just be rearing its ugly head. That crisis is inflation. Central banks all across the globe and especially in the US have pumped trillion of dollars in the economy. That jolt was needed to push the economy back on the path of recovery. However, they say there are no free lunches in economics. One of the downsides of this unprecedented amount of spending is a risk of inflation.
What is inflation?
Inflation in simple terms is a rise in prices of good and services in the economy. Loosely speaking when there is an imbalance between the amount of money and the goods and services that the money chases, often it leads to rising inflation. The surge in money supply as a result of the Fed spending has that balance heavily lopsided right now. If for anything, a testament to the theory of rising inflation has been a surge in bond Yield we saw in the recent weeks. The price of a bond (or any fixed income instrument) is negatively correlated with inflation as inflation eats into the real purchasing power. Yields move inversely with prices and with the rising fear of inflation, have been climbing up in the recent past.
Why is inflation a risk?
One wonders what inflation has to do with real estate especially income producing real estate. Real estate of often touted as one of the best inflation hedge plays out there. Why is that? Its rather simple to understand that. Income producing real estate derives its value from its income producing potential or rents. Rents are very strongly correlated to rising inflation and typically outstrip inflation in terms of their year over year increase. As rents increase, the value of income producing real estate tied to those rents also increases. Some indirect ways of increase are related to a rising cost of replacement in an inflationary world. Simply speaking, it costs more to build and replace the asset. Rising inflation often has a pretty dramatic impact on the valuations of income producing real estate.
While time will tell how high inflation rises to in the US or the magnitude of its impact, it sure is a clear and present danger. We opine that now may be a great time to diversify into income producing real assets, which as we discussed, are structured to do well in an inflationary world.