When inflation is zero, it doesn't mean property operating costs remain flat. In the title of this article, I connect zero inflation with cost-cutting measures in property operations. Why? Because, usually, zero inflation means that property owners have no pricing power to raise rents.
Sure, rents can rise in hot markets or when there is a significant imbalance between supply and demand. Otherwise no. Just no - there will be no rental increases and no rent growth when inflation is zero. That doesn't mean property operating expenses will remain flat, however.
When a utility provider decides it's time to raise rates (electricity, water, gas, Internet) as a property owner, your costs rise. A simple one percent increase in common area utility expense affects Net Operating Income (NOI). The same is true for increases in insurance or property taxes - a property has no authority to sidestep increases in these expenses. The "yea but" arguments are outliers. Of course, you can sometimes shop the market.
When inflation is zero, and fixed costs are rising, you need property-specific cost-cutting strategies to keep the ship afloat and make a path forward with less financial pain. For this reason, I am suggesting a direct connection between zero inflation and property operations cost-cutting measures.
The year 2020 could be the first time the U.S. inflation rate registers at zero. Projections right now are for just over one-half of one percent. The closest we have come to the goose egg - when inflation is zero - in recent times was 2009 when the official inflation rate was 0.1%. According to the U.S. Inflation Calculator, since 2010, inflation has ranged from 1.2% - 3.0%.
The year-end number for 2020 will likely fall below this range, with 2021 projected at 2.1%. In this conversation, I am excluding the possibility of deflation. However, given the rise in unemployment, it may be more than a whisper if the economy suffers successive quarters of downward pricing pressures from a lack of demand.
Deflation: An Overview. Inflation occurs when the prices of goods and services rise, while deflation occurs when those prices decrease. The balance between these two economic conditions, opposite sides of the same coin, is delicate, and an economy can quickly swing from one situation to the other. Inflation vs. Deflation, What's the Difference? - Investopedia
The primary driver of rental property appreciation are increases in rental income and inflation. When inflation is zero, appreciation is harder to come by. When real estate property prices decline, there is no corresponding revenue stream for rising property operating costs; the cost of operating and maintaining real estate assets can continue to grow concurrent with flat income, year after year.
I have experienced this personally and professionally, having ownership and asset management responsibilities in markets around the country where "everything" went haywire, where potential residents had the power of choice.
When two competing properties with similar amenities are competing head-to-head for new business price (rental asking price less concessions) is the fallback, the go-to method to gain that extra lease. When properties compete on price alone property owners lose. As revenue decreases, property owners lose money and the ability to re-invest into their assets from revenue.
As the costs of individual inputs increase, so does the price of the final output. A simple example is that if both lumber and drywall costs increase, then the costs of newly constructed homes are higher as these items represent a large part of the cost of materials in a new home.
The problem comes in when, for example, two home builders with similar products are facing a single buyer. Pricing power diminishes even though their cost of construction is higher. The same principle is true with rental property when fixed and variable costs are increasing in the face of flat or falling rents.
There are five basic ways to make money in real estate; one way is with appreciation. Read more in my post, "Five Ways Investors Make Money in Real Estate."
Let's stretch our thinking beyond the basics. When appreciation is only regional, do you chase it? The U.S. coastal markets have seen some significant upside for years. Well, what if you live somewhere else? Do you re-direct your real estate investment to the "hot" markets? Probably not. The herd mentality always shows up late, like the lineage of people who purchased Apple stock at $700 and followed it down to $377 without a stop-loss (the cycle never ends).
Most people who invest in real estate assets under $5M place all of their real estate investment allocation their money into deals near their zip code. This form of real estate investing is seldom a good strategy, particularly since it negates geographic diversity. I get it - people are most comfortable in geography they know. Recognize, however, investment yield doesn't care about your sentiment or whereabouts. Investment yield doesn't care what your friends think; it follows opportunity, wherever the opportunity.
So if not in your own zip code, then where? The "where" is really secondary to what you bring to the investment. If all you bring is money trouble is brewing because money alone doesn't make any investment work for the investor. What makes any investment have an opportunity for success is professional management or oversight. The same is true in real estate investing; wherever you invest, bring/have/require professional property management.
With appreciation removed from the overall yield-enhancing equation, real estate investors must focus on financing and operations. Pick a city, any city post-recession. Phoenix, Arizona, saw genuine appreciation with residential prices moving up 20%+. Yet, even with this move, home prices remained severely below pre-recession levels.
What happens if real estate investors stop chasing appreciation? What happens if inflation never rises to save us from our operational malaise? Real estate investors must focus on long-term operational stability and rent growth. The best strategy is to perform cost-cutting where you can and take price (rental increases) at every opportunity.
Real estate has never been a passive investment. When a yield driver (appreciation) disappears from view, this necessitates more attention to other property attributes, including better systems to control costs. Focus on property competitive advantages, no matter how small. Make the leasing experience as easy as possible. Do all the little things, including answering every phone call.
Growing revenue and controlling expenses requires real estate investors to focus on present-day operations and away from potential appreciation as an operational "savior." It makes real estate investors realize that appreciation in real estate value is a gift and not a right.
Growing Revenue and Controlling Expenses (G.R.A.C.E) is impossible without healthy relationships in the apartment business, with customers, staff, service providers, and vendors.
Without outstanding relationships surrounding your assets, failure is assured. It's fine to focus on the numbers, but it is our people; property management, contractors, vendors, lenders, and banks that create the momentum necessary to make good progress. The three things in a perpetual dance in property ownership are; our people (named above), the paperwork (from leases to mortgages, insurance, and vendor contracts), and the property.
Regarding appreciation from inflationary occurrences, it is a beautiful thing for property owners. However, it's a thing we can't control or force to occur. The proactive mode is to work on those things we can control.
Review each asset in your portfolio and consider the following thirteen cost-cutting strategies:
These methods do not require asset appreciation to create value.
Will inflation return? Of course. It always does. But like stocks, we can't time the market, so direct your professional efforts to create value within your real estate holdings during any market condition utilizing professional property management, local market expertise, common sense, and knowledge of the business.
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