Positive Effects of Inflation in Real Estate
The word “inflation” tends to carry a negative connotation for most people. However, it is not as detrimental as one might believe. Nor the relationship between real estate and inflation as complex. In order to fully comprehend how the two are intertwined, it is best to start with an understanding of exactly what inflation is and what it is not. Also, what is the impact of an inflationary trend? Afterwards, we will examine key aspects of real estate that are positively affected or impacted by inflation. What might be the best way to hedge, or protect, against inflation. Finally, the positive influence that inflation has on the real estate industry.
What is inflation?
Inflation is defined as an increase in the price of goods and a decrease in the purchasing power of the dollar and services over a certain period of time. In other words, inflation is a general rise in the price level. It is important to differentiate between inflation and appreciation. Inflation is not appreciation. An appreciation rate as it relates to the real estate industry is the increase of a property’s value over time.
With appreciation, the value of the property does not increase in relation to the currency. It will actually increase based on demand. It is a plausible and likely scenario to have a home appreciate more than the inflation rate. Conversely, it may also depreciate in an inflationary economy.
Historically speaking, over the past 10 years, the average rate of inflation in the United States was 1.8%. However, some experts are predicting higher rates of inflation as a result COVID-19 on the economy. This is due to the enormous amounts of shuttered businesses, people out of work, and the large injections of stimulus money stemming from the federal government.
What is the impact of an inflationary trend?
When saying there is an inflationary trend, it is not implied that there is an isolated rise in price. It simply means that prices have been rising across all market segments.
Inflation can have a seismic impact on the performance of a wide range of real estate sectors and investment portfolios. Times of high-inflation can create a tipping point; either make or break a real estate investment.
Effect on Homeowners and Property Owners
How does inflation help homeowners or more explicitly, “mortgage owners”?
- It reduces the real value of their mortgage
- It may also increase the value of their home
On the other hand inflation also benefits property owners due to the fact that it can be difficult to get a mortgage. Why? It is because high-cost mortgage rates often leave buyers with less purchasing power. Thus, the result is that many will continue to rent rather than purchase homes. This situation happens to be beneficial to those who own rental properties or are landlords.
Effect on Housing and Real Estate Prices
Housing prices tend to rise with inflation. Without the pressures of economic supply and demand, the price of goods will remain the same. Should the only variable to this economic equation be the addition of money, then the price of goods will increase. Naturally, the economy is dynamic, not static. But when influencing factors are relatively small, the more money fluctuating in circulation will provide a quicker increase in the price of almost everything, including housing prices.
The reason inflation increases real estate prices is simple economics:
- Cost of construction for new homes increases
- Real estate developers will try to pass those increased costs to the consumer
- The increase in the price of new homes will increase the demand for existing homes as buyers look for an affordable alternative
- All things being equal, the increase in demand will lead to an increase in the the price of existing homes as well
Effect on Debt
It can be said that a basic rule of inflationis that it causes the value of a currency to decline over time. In other words, cash now is worth more than cash in the future. Thus, inflation lets debtors pay lenders back with money that is worth less than it was when they originally borrowed it. Examining one’s overall financial situation, there’s both “good” and “bad” debt. Good debt is borrowing that helps you build long-term wealth. Bad debt can harm your credit and deplete your finances. How do you differentiate between the two?
Good debt is debt that is used to pay for something that has long-term value and increases your net worth (such as a house) or helps you generate income (such as smart investments). Without taking on good debt, it may prove difficult to buy a home or even get a loan for your child’s college education.
A common example of bad debt is credit card debt. Given that the average card balance is over $6,000 per person, it’s considered bad debt because of the high interest rates. Another example of bad debt is car loans. Why? They’re used to borrow money to buy an asset that depreciates.
Best ways to hedge against inflation
Regardless of the current economics, there are things real estate investors can do to hedge, or protect their portfolio against inflation. Below are some examples of real estate investments that tend to fare better than others in a high inflationary economy:
- Real Estate Investment Trusts (REIT): These will follow the market demands and appreciation similar to that of physical real estate and can be a good way to distribute your investment across a large number of assets.
- Rental properties: Including commercial, residential, multi-unit, and single-family homes. These will likely have a higher than normal demand and return on your investment.
- Note investing: Financial institutions and banks may be offloading higher than normal quantities, thus resulting in less competition and lowered prices.
The ability to have funds available to seize an opportunity, when needed, is paramount.
So all the above now begs the question; is inflation actually good or bad for real estate? Or a better question is, how well does real estate perform during inflation?
Inflation causes everything (costs and expenses) to rise. So as the cost of living increases, the more employers are forced to, for the most part, pay employees more. Thus job wages increase and the population has more income available to spend. Property values and real estate prices increase. Landlords can then charge more rent. All culminating into creating an upward cyclical economic trend.