The combination of a little inflation along with low-interest rates should be attractive to Solo 401k real estate investors. You might notice the close relationship between inflation and interest rates every time the Federal Reserve decides whether to increase, decrease, or maintain the interest rate. Typically, comments from the Fed regarding interest rate changes are meant to stimulate the economy or discourage inflation. On April 28, 2021, Federal Reserve Chairman Jerome Powell commented that the economic recovery is “uneven and far from complete.” He further said that inflation pressures could rise in the coming months. However, he noted these “one-time increases in prices are likely to only have transitory effects on inflation.” Earlier in April, Powell also stated, “it’s highly unlikely” the Fed would raise interest rates any time this year.
All of this is part of a plan to get the economy moving again and keep it growing.
Low-interest rates during a period of moderate inflation should be good news to all investors and especially to real estate investors. The formula is relatively simple. Low-interest rates make it less expensive to borrow investment money. Especially mortgages for real estate purchases. At the same time, inflation triggers collecting higher rents from those investment properties. Every investor wants lower expenses and higher income. Something you may want to know is that the Solo 401k is exempt from paying UDFI – the mortgage tax. This is a big deal if you plan to get a mortgage for your 401k-owned property.
Most Real Estate Investors Don’t Hate Inflation
Two weeks before the Fed announced the unlikelihood of raising interest rates, the Bureau of Labor Statistics reported that the Consumer Price Index (CPI-U) (https://www.bls.gov/news.release/pdf/cpi.pdf) had gone up 0.6 percent in March. Since then, it went up another 0.8% in April. That’s the most inflation has risen in a single month since August 2012. It also sounds terrible to most people. Most economists attribute the increase to gas prices that slumped in 2020 during the worst of the pandemic. Some of it is also attributed to recent government stimulus activity. Those are part of the reason why the Fed believes that current inflation is transitory.
Normally, the Fed raises interest rates when inflation reaches an unacceptable level. The reason is because interest rates and inflation have an inverse relationship. Higher interest rates slow borrowing because borrowing becomes more expensive. When consumers borrow less money, economic growth slows to reduce inflation.
What is very important to note is that the Federal Reserve is NOT pursuing the traditional inverse relationship this time. Instead, the Fed wants rapid economic growth. The plan is to keep borrowing inexpensive money at the same time that inflation is increasing relatively rapidly.
Overall, the economic outlook looks strong, which is wonderful. People are going back to work. Mortgage rates remain at historic lows. And most investors expect continued strength, at least for now, in the housing market. Homes continue to have highly appreciating values, at least for now. For real estate investors, this is good news on many fronts. Inflation and the hot real estate market will drive rents higher (more business income) while mortgage rates remain low (lower business expenses). Let’s also remember that rent moratoriums will be expiring. Solo 401k investors holding real estate may hope for a very good year.
How Real Estate Can Outperform Inflation
Real estate is a scarce and highly desirable commodity. That gives it a fundamental value that has historically outperformed inflation. In fact, during these inflationary times, existing houses (and other existing buildings) might increase more in value than investing in new houses due to the inflationary costs associated with materials and labor to build a comparable house. For instance, lumber prices increased almost 90% on a year-on-year basis in April, according to the latest producer price data.
Some inflation is not necessarily a bad thing because it forces people to not just horde their cash. When the value of cash is diminishing, people will put that cash to use. It encourages some spending and investments, and that helps to grow the economy. Along with many other products (like bread and milk), housing isn’t a luxury, it’s a necessity. People will always spend money on housing.
We all know that appreciation of a real estate investment is only one of the ways that real estate investors make money. Investors also make money through monthly cash flow (income). As inflation and the cost of goods goes up, so do wages to match. As wages increase, so does the cost of rent. So as a property owner, you’re able to increase rents to stay current with inflation at a minimum. That’s part of the reason why the cost of rent seems to increase at least 3% every year.
Real Estate as a Hedge
Still, houses have to be properly rent-managed during inflationary times. Here are a few common ways to link rents to inflation:
- Include periodic rent reviews in leases. Tenants then understand the link between rent prices and inflation. Many property management companies include rent reviews in their leases.
- Less common with single-family houses but more common with multifamily and commercial properties is directly tying leases to the CPI Index. This became fairly standard in the 1970s and ‘80s when inflation was more prevalent.
- Be aware of operating and capital improvement costs that are rising due to inflation. In particular, materials, services, and utilities are likely to increase with inflation. Many of these costs can be passed on to tenants.
Multifamily Rental Investment Strategy
Real estate investors with various strategies expect to do well in this unique economic environment. However, multiunit or multifamily rentals should be positioned to do exceptionally well. To begin with, low-interest rates could be the financial key needed to step up from single-family rentals to multifamily rentals. Adding to the enticement can be the easier ability to steadily increase the rents collected from multifamily units.
Multifamily rentals consistently have leases expiring, which is the most common time for rent increases. Some multifamily buildings have shorter lease periods in the six to nine month range. Each of these conditions is inflationary friendly. Another reality is that multifamily rentals have a higher rate of turnover, which is another time to make an inflationary adjustment to the rent. Multifamily properties also provide more flexibility with staggered lease expiration dates that allow for inflationary adjustments throughout the year. Furthermore, well-managed rental rates contribute to increasing the value of the rental property.
Today’s low-interest rates are the time to lock in long-term, fixed-rate loans. Low-interest mortgage rates will keep debt payments lower and stable in periods of rising inflation. Having fixed debt payments while rents and property values grow has the potential to be very advantageous for investors.
Today’s economy will not last forever. Inflation is still tied to interest rates. Low-interest rates will go up at some point. No one knows exactly what is going to happen but when inflation and low-interest rates are running in tandem, economic growth could happen very fast. Mortgage rates could go up in a matter of months or even weeks.
