Most of us are currently facing financial stress due to two factors. One, household inflation is high. And two, interest rates are low. The question is: How should you manage your inflation risk to reduce your financial stress? In this article, we discuss how you can invest in real estate to moderate your inflation risk. This article is a follow-up to our discussion on inflation-hedging published in this column on December 9, 2012.
Why bother
You have to meet your current living costs and also have to save some money to meet future liabilities with your monthly income. Now, rising price levels can stress your cash flows. Why? You will require more money to meet your monthly living expenses. After all, price levels have gone up on most household goods; this could leave you with lower monthly savings to meet future liabilities. But low interest rate would require you to invest more money in bonds to meet your future liabilities. And even if interest rate increases, it is highly unlikely that the increase in rate will keep pace with the rise in price levels of household goods.
Besides, it is moot whether the situation of high inflation and low interest rate will ease soon. Why? For one, crude oil price can go up further. This would stress the country’s deficit and also increase general price level.
For another, RBI could keep interest rate low to spur economic growth. And adding to this, if rupee depreciates against the dollar, the landed cost of imports will increase, leading to higher price level in the country.
Your income is unlikely to always keep pace with inflation. Besides, our market does not offer inflation-adjusted products such as those available in the US. This leaves you in a spot. So, how should you moderate your inflation risk?
Real assets
In the absence of inflation-adjusted investments, you should turn to real assets such as real estate and precious metals to help you moderate your inflation risk. The problem with gold is that the yellow metal’s price is highly volatile. More than being an inflation hedge, gold is a good investment to moderate investment risk during global crisis. That leaves you with real estate to moderate inflation risk.
Real estate can help you moderate inflation risk because rental income keeps pace with inflation. That is, you can typically increase your rent each year to keep pace with the general price level, especially if you have a lease agreement with your tenant(s). Besides, you do not have to reduce rent when general price levels decline, except when the economy slips into a recession.
There is, however, a flip side to investing in real estate. The inflation-hedge that real estate provides may be lost if you have to take a mortgage to buy your property. Why? Banks will offer you floating-rate loan. So, if interest rate goes up because of inflation, your mortgage cost goes up as well. And that may negate the benefit you may derive from inflation-adjusted rental income. You should, hence, consider higher down payment and smaller mortgage to buy your property. One way to do so would be to sell some of your equity and bond investments to buy real estate.
Volatility
It is tempting to suggest that you buy commercial real estate. But buying residential property would be a better choice for moderating your inflation risk, especially if you are a retiree. Why? For one, commercial rentals can be more volatile than residential rentals. For another, the initial capital required to buy residential property will be typically lower than that required for commercial property. And just as with equity, investment selection is important for real estate. You should buy a property that offers a good return on investment- rental-to-investment capital ratio.
(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investorlearning solutions. Feedback may be sent to >knowledge@thehindu.co.in )