Trends in a Stagflationary Environment

August 17, 2011

I read an interesting article the other day, written in 1992, which talked about how the only thing holding up in the New York economy was rents at the bottom end of the market. It got me thinking about the process here and if this would be the case right now in cash flow oriented housing investments.

Let us set the scene –

We are at a time of uncertainty in USA. Will the treasury print more money? Will inflation turn to hyperinflation? Will interest rates have to rise soon? If so, by how much?

By 2010 23% of US homes were in negative equity, and in Spring 2011, almost a million homes in USA were in foreclosure, several million in the process, and 872,000 previously foreclosed homes with the banks.

Despite being in a potentially inflationary environment, there seems to be no upward pressure on salaries.

With salaries stagnant, and the cost of basic goods (food, clothing, transport) increasing – where does that push people in terms of housing? What trends will come out in an inflationary environment where a large number of the population has taken a financial hit?

– Less people can get a mortgage, so pressure for rentals increases
– Less new homes are being built for sale
– Population is still increasing so housing demand is still prevalent albeit in terms of rental demand and less purchase demand
– With less spare cash, people will revise their housing budget downwards (i.e. middle market foreclosed families may seek to rent budget accommodation instead)
– Demand for budget rental accommodation increases

However, in the same way as even poor people need to eat but always have a ceiling on what they can afford, rents for budget accommodation cannot rise above a certain affordability. The market demand simply cannot afford the product.

So how can an investor ride a smoother path to increasing rents in this environment?

One way to benefit from a rising demand for budget rentals from potential middle class tenants who previously were not renters, would be to buy in ‘gentrifiable’ areas. Neighbourhoods adjacent to more upmarket neighbourhoods are a good bet here. For example, the areas surrounding affluent Allentown in Buffalo are already catching the overspill from middle class tenants who can no longer buy, and cannot afford the higher rent of the more upscale neighbour.

Common sense buying points in the cashflow investor checklist, like focussing in areas with good quality architecture and a low number of empty homes, also helps the investor choose a better quality tenant.

The trends in ‘gentrifiable’ areas in a recession is likely to be self fulfilling through the next recovery, since you can choose a better quality of tenant in a recession (demand will be high but there will be a ceiling on what you can realistically charge) and when the economic outlook improves, the areas are more likely to move upmarket in terms of perception (for example Hackney, London).

Alan W. Findlay is a Partner in Abbotsinch Capital with more than 15 years of experience in real estate investment.

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