Does inflation swindle the real estate investor?
Probably not
In 1977, Warren Buffett published a lengthy article making the counter-intuitive argument that inflation is bad for equity investors.
Buffett: How Inflation Swindles the Equity Investor (csinvesting.org)
It's an interesting article, and as with everything Buffett has written, it is worth reading.
But I don't think it applies to real estate. Or rather, by Buffett's own reasoning, real estate equity investors are likely to benefit from inflation, for the same reason that investors in most other industries will suffer from inflation.
The crux of Buffett's argument is as follows:
Return on Equity is the core metric that determines long-term value creation.
This can be further broken down as follows:
Of those five components, Buffett argues that none of them are reliably improved in an inflationary environment, and some of them are hindered.
Let's go through each of them.
(Revenue / Assets) -- this is asset turnover. Buffett starts with this one, and spends the most time on it. Basically, he says that while most businesses will get a temporary increase in this ratio when inflation sets in, it is not permanent.
For example, if you have a widget machine which cost $1 million and makes 100,000 widgets per year which you sell for $10, that is a 1.0 Revenue / assets ratio. If, due to inflation, widgets now go for $15 instead of $10, you will suddenly be producing $1.5 million in widgets per year, which is a 1.5 revenue / assets ratio. And that's great, bully for you, but sooner or later you will need to replace the widget machine, and the replacement widget machine is probably going to cost $1.5 million, bringing you back to a ratio of 1.0.
(EBIT / Revenue) -- This is about operating margins. Buffett argues that since inflation affects both revenues and costs, it should not materially affect operating margins for the average business. He points out that corporate pretax margins averaged 8.6% from 1956 - 1965 (low inflation), but decreased to 8.0% from 1966-1975 (high inflation).
(EBT / EBIT) - this is Earnings Before Taxes divided Earnings before Interest and Taxes. In other words, it's about interest expense. Interest rates should increase--not decrease--when inflation is high. So no joy here either.
(Income / EBT) -- this is about the income tax rate. Unless you expect taxes to decrease in an inflationary environment (and why should you?), this ratio won't go up either.
(Assets / Equity) -- this is leverage. Leverage is probably going to go down in an inflationary environment, because interests rates are going up. If interest rates are going up, you can't borrow as much if you are being held to a fixed debt service coverage ratio.
So that's the gist of Buffett's argument. It's a bit subtle, but when you break it down, it makes sense. And I think all equity investors should grapple with it.
Why this doesn’t apply to real estate
That said, I don't think it is very applicable to real estate. Specifically, this is because Buffett’s argument about asset turnover (Revenue / Assets) do not apply to extremely long-lived assets like buildings.
Buildings -- unlike widget machines, let alone inventory--last for a very long time. Inventory may spoil after a few months. Widget machines wear out after a few years. Buildings last 50-100 years. Here is Buffett talking about fixed assets and asset turnover (emphasis added):
In the case of fixed assets, any rise in the inflation rate, assuming it affects all products equally, will initially have the effect of increasing turnover. That is true because sales will immediately reflect the new price level, while the fixed-asset account will reflect the change only gradually, i.e., as existing assets are retired and replaced at the new prices. Obviously, the more slowly a company goes about this replacement process, the more the turnover ratio will rise. The action stops, however, when a replacement cycle is completed. Assuming a constant rate of inflation, sales and fixed assets will then begin to rise in concert at the rate of inflation.
The bold part is the key. It's not that Buffett is wrong, it's simply that Buffett is describing the economy at large. He is not suggesting that all companies will suffer in an inflationary environment--in fact, he specifically describes the circumstances in which a company’s asset turnover would benefit from inflation. Namely, a company that only has to replace its assets "slowly".
The canonical example of this in Buffett-land would probably be a company like See’s Candies or ABC / Cap Cities, whose biggest assets are intangibles which barely deplete at all.
But it also applies to real estate.
For example, if you buy a 20 year old building for $10 million with an NOI of $500K, and due to inflation the NOI rises to $1 million, you really have increased your ROE. Sure, this effect will dissipate if you have to raze the building and construct a new one for $20 million, but realistically you aren't going to do that for at least another 30 years. That is completely different from the widget machine which needs to be replaced every few years.
By the way, this does suggest that real estate developers--or anybody buying new construction--should be cautious about investing in an inflationary environment, because they are literally replacing (or creating) fixed assets at today's high prices. But I haven't thought about this deeply, as I prefer to buy used.