What Happens to Real Estate During Periods of Inflation?
April 14, 2022
You've heard of real estate as a hedge against inflation, but what really happens to it, and is it a good to invest in during periods of high inflation?
Here's everything you must know.
What Is Inflation
Inflation means rising prices. That gallon of milk you used to buy for $2.00, for example, might cost $3.00 now. Inflationary periods are typically measured annually, but lately, we've heard about monthly rates because it's changing at such rapid speed.
Another way to look at inflation is that it decreases the purchasing power of the dollar. What you used to be able to get with a dollar, you can no longer get because it costs more money. You need more money to buy the same things when the inflation rate increases.
Everyone wants to point their finger at something when inflation occurs, and understandably. However, higher consumer prices make it hard to afford what you usually buy and when you need to buy big-ticket items, it can be even harder.
Here are a few of the common reasons inflationary periods occur.
Lax Monetary Policy
When the monetary policy is relaxed and the government prints too much money, it causes the dollar to be worth less money. We're seeing this now with the stimulus money printed when the pandemic hit, and they increased the money supply. It was one of the government's largest aid packages, but now it's hurting the economy.
The more money there is in circulation, the higher the demand for products and the higher consumer prices increase.
We've seen our fair share of supply issues throughout the last two years. As a result, things we used to take for granted are no longer available. This has been due to many issues, from natural disasters to shutting down businesses due to the pandemic.
When there is a smaller supply than demand, rising prices are the norm. We've seen much higher prices than ever before because of this issue alone.
We haven't seen demand shocks in a long time, and the industry that's seeing it the most is the real estate industry. Buyers are bidding prices much higher than the seller's asking price, and buyers are paying it.
The crazy demand for certain products is a big reason for the inflationary market. Buyers are willing to pay whatever it takes to get what they want, pushing out the 'normal' consumers who can't afford this tactic.
Expectations of Risings Costs
Sometimes we manifest rising prices without realizing it. If you expect prices to increase, they will. For example, rent prices often increase because the market expects it to happen. Consumers see that the inflation rate is high, so they say, 'I know my rent will increase.'
Of course, what real estate investor wouldn't take advantage of the opportunity to increase rent prices if it's expected of them?
Inflation vs Real Estate
Inflation and real estate go hand-in-hand. Real estate could be a good option if you're looking for an inflation hedge. It can be great for sellers and real estate investors, but it's not usually the best for buyers.
Here's how real estate and inflation are related.
Income Generating Asset
Investment real estate is an income-producing asset. Real estate investors charge rent to tenants monthly, which they use to offset the cost of owning the property. During inflationary periods, investors can charge higher rents, covering their higher prices and hopefully walking away with a profit.
Hedge Against Inflation
The appreciation rate of real estate often accelerates during inflationary times. This makes real estate a great hedge against inflation. Investors can charge higher rents and earn equity faster in the home, which helps offset the higher cost of other goods and services.
Property Values Increase
Property values increase during times of inflation because the price of materials increase for builders. If builders have to charge more for the homes they sell, the rest of the market follows suit. This makes a real estate investment a good hedge against inflation.
If property values increase, real estate investors earn equity faster, and if you sell the property, you earn higher capital gains.
Limited Available Real Estate
Real estate is a limited resource. No one can create more land, so real estate investing can be a great way to deal with high inflation. Since everyone needs somewhere to live, the pressure demand causes can increase real estate prices.
Housing Construction Costs Increase
The high cost of just about every material and labor increases the cost of housing construction. If it costs more to build a house, the trend will trickle throughout the entire area, making real estate a good investment for anyone trying to fight the inflationary environment.
Higher Mortgage Rates
Inflation often causes higher mortgage rates, making it harder for the everyday buyer to afford a home. When buyers can't get a mortgage, they will continue to rent, which is good for investors who bought rental property.
Increased Rental Costs
Real estate investors earn more money from charging higher rents, but they also have higher rental costs. It costs more money to run the property, including keeping the utilities going, affording the property taxes, insuring the property, and maintaining it.
How Is Real Estate a Hedge Against Inflation
Because housing prices increase with inflation, real estate can hedge inflation. Here's how.
Appreciation Offsets Inflation
When housing prices increase, property owners make more money. This helps offset the higher costs they pay elsewhere in their lives. When investors make more money on their investments, they can keep the value of their dollar higher than the pace of inflation.
Rental Properties Generate High Returns
Historically, the real estate market offers high returns, much higher than the stock market or any other investment. While there's no guarantee a piece of real estate will definitely outpace inflation, home prices typically increase with inflation and provide higher returns.
Commercial vs Residential Real Estate
Real estate investors have many options when investing in real estate assets to offset inflation, including commercial and residential real estate.
Both can help offset the inflationary pressures, but you should be careful with commercial investments. Since businesses must succumb to the higher costs, their business may suffer, which could result in them defaulting on their rent and leaving you with a loss.
This doesn't mean residential real estate investments don't have risks. While you're providing a place for tenants to live, there's always the risk of defaulted rent and/or unexpected vacancies.
Other Ways to Profit From the Housing Market When Prices Rise
If investing directly in real estate doesn't sit well with you, there are other ways to take advantage of rising home prices without dealing with higher interest rates or owning physical real estate.
Real estate investment trusts are investments in real estate without owning property directly. Instead, with REITS you buy shares of a trust that owns and runs mostly commercial properties, but this can include things like apartment buildings for tenants.
You might be able to take advantage of fractional investments by investing in a property with other investors. You each own a portion of the property and earn a prorated amount of the returns. This is a popular way to own commercial real estate without investing hundreds of thousands of dollars.
What Happens if Interest Rates Rise?
Rising interest rates make it harder for borrowers to afford loan payments. This can lead to a larger rental market versus buyers, which can be good for real estate investors. If you own income properties, you can earn the rental income that buyers would otherwise use on a mortgage payment.
Do Mortgage Rates Correlate to Inflation?
Mortgage rates rise in response to inflation for two reasons. First, the Fed usually increases rates to slow the demand. Second, lenders need to increase rates to increase their own purchasing power for other loans. Since lenders' costs rise, they have to pass it along to borrowers for them to stay in business.
Will Inflation Cause Real Estate to Crash?
Inflationary pressures likely won't cause real estate to crash, but the Fed's point in increasing interest rates is to slow the demand. So far, the demand still exceeds supply which continues to increase real estate prices and profits real estate investors earn.
What Happens to Commercial Real Estate During Inflation?
Commercial real estate can be a great investment to fight inflation. When consumers can't afford a mortgage because of higher interest rates, they turn to rental properties. This helps commercial real estate keep its value or even increase.
The Bottom Line
It's common to worry about asset prices during inflation, including real estate. The good news is that real estate usually holds its own during an inflationary market and can be a good investment if you're looking for a way to offset the higher cost of the goods and services in your life. Learn more by signing up and visiting our blog.
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