Potential Effects of Inflation on Rental Income

The income produced by an apartment building is driven by the rents you collect minus the cost of procuring those rents; building management, maintenance, and
debt service. Debt Service is such an important topic I’ve decided to cover it in greater detail separately in a future letter. The rents you collect and the expenses you must pay are affected very differently by inflation.

There are two key phenomena that benefit apartment buildings during hyperinflation:

· Rental Rates Are Sticky

· Vacancy Rates Rebound Quickly

Absolute rental values and vacancy rates determine your property’s gross income. Rental rates are primarily driven by the average income of the demographic interested in a particular unit type. The more money people make the more they are able to afford for housing. As wages go up, rents tend to follow. During harsh economic times many people lose their jobs or find their regular salary increases postponed. Employers generally prefer to reduce the total number of employees rather than renegotiate individual wages and maintain more employees. This is where the first interesting phenomenon begins to manifests itself.

Rental Rates Are Sticky - Apartment rents tend to react very slowly to economic downturns and increasing unemployment. I believe this is for two reasons:

Average income levels remain fairly constant despite the overall reduction in cost to employers, i.e. if someone is able to keep their job, they will keep it at the same salary and be able to afford the same rental amount. (Chart A demonstrates how per cap ital income remained steady despite high inflation rates during 1979-1982) Click on Chart to Enlarge Image

In addition, shelter is a basic human necessity; it is an “inelastic” commodity where people will divert funds from other nonessential expenses to keep a roof over their heads. Fortunately for apartment owners in the United States, apartments are one of the least expensive sources of shelter. Sure the rents of high-end units will suffer as people downsize to smaller units that reflect their reduced income but, because apartments are at the bottom of residential market, they stand to benefit from downsizing.

The mechanism of downsizing to reduce costs is where we see increased Vacancy Rates come into play. Unlike rental values, vacancy rates tend increase more dramatically during hard economic times because of the number of people downsizing and sharing homes temporarily. I would argue that increased vacancy rates are the primary source of rental income reduction in hard economic times, not the reduction of absolute rental values.

Vacancy Rates Rebound Quickly – Fortunately, the effects of vacancy are slow to filter through the multi-family market. The height of vacancy rates is usually significantly delayed from the beginning of an economic downturn and in some cases it is not affected at all (See Chart B). This phenomenon can lead to rental markets recovering quickly. Once more jobs are available, apartment owners can aggressively fill vacancies at rental rates similar to the previous market heights. As incomes bounce back enough to compensate for the increased cost of living, apartment owners can expect a steady appreciation in rents. This increased income coupled with reduced cap rates from the stronger economy causes apartment property values to rebound much faster than other forms of Commercial Real Estate.

The outlook isn’t all Rosy… Income is only one half of the cash flow equation. Unfortunately, Expenses don’t behave as favorably in high inflation. Rapidly increasing costs and looming debt requirements can put owners in a perilous place during hard economic times. Property valuations will decrease in the short term and there is little hope for immediate upside from appreciation. The gains for holding on through the rough times will be substantial but very difficult to obtain.

The good news is that as an income-producing property owner you are already one step ahead of most of the nation and own something of intrinsic value that should be paying you a good stream of income. As long as you have a good mortgage in place and own a well-located property, you will be insulated from the worst. Avoid the temptation to blindly follow the next fad the media gets hold of, things aren’t the way they used to be. During the buildup of the last great bull market, the biggest mistake you could have made was to sit on the sidelines. Things have changed. Today, you stand lose more than you do to gain. America is experiencing a master reset of the balance between risks and returns. No one knows when we will reach equilibrium but I am willing to bet that the “New Normal” won’t be anything like what “Normal” was in 2007. Mark Twain purportedly said it best, “History does not repeat itself, but it does rhyme.” I’d suggest taking a step back and taking a critical look at your true goals of ownership. As an expert in investment real estate, I can help you wade though pitfalls of acquisition, ownership and disposition. If I’ve struck a chord, give me a call at (415) 307-4207 or e-mail me at Conor@ConorMusgrave.com.