Inflation significantly affects the economy, leading to an increase in the prices of goods and services. This phenomenon has far-reaching implications, including notable impacts on the real estate market.
Understanding how inflation influences real estate is crucial for investors, homebuyers, and sellers. This knowledge can guide them in making informed decisions when buying or selling property.
In this article, we will explore the causes of inflation, its effects on real estate, and strategies that real estate investors can use to benefit even during periods of high inflation.
Understanding Inflation and Its Causes
Inflation occurs when your money doesn’t stretch as far as it used to. This is primarily due to an increase in the money supply and rising levels of debt.
The central bank has significantly boosted the money supply over the years, leading to more dollars in circulation. Consequently, businesses can charge higher prices for goods and services because, in theory, people have more money to spend. However, inflation typically occurs when incomes do not rise at the same pace.
Inflation happens when the economy isn’t growing fast enough to match the increase in the money supply. If companies cannot produce enough goods to meet demand, they will raise prices for the available products.
To control inflation, the Federal Reserve often raises interest rates. Higher interest rates can curb consumer spending and help reduce inflation.
As people spend and borrow less, companies have the opportunity to replenish and build up their supplies. However, it can take several years for the economy to stabilize or grow after a period of high inflation.
How Inflation Affects Real Estate
Inflation generally results in higher home prices. The value of your money decreases over time, so a house that cost $400,000 last year might now be priced at $450,000. If interest rates are also high, this further increases the cost of purchasing property.
However, if you already own real estate, you may experience increased equity during periods of high inflation. While this can benefit your financial situation, it can also make it more challenging to expand your real estate portfolio with additional assets.
Real Estate as a Hedge Against Inflation
Many investors view real estate as a strong hedge against inflation, primarily due to the impact of rising interest rates.
For example, if you purchase a home with a 5% fixed interest rate mortgage, and two years later, interest rates rise to 7% due to inflation, your mortgage payment will remain lower compared to a new mortgage taken at the higher rate. This, combined with increasing property prices, makes real estate less affordable for new buyers.
Using real estate as an inflation hedge often requires a long-term investment strategy. The real estate market can be volatile, with short-term corrections affecting property values. During economic downturns, you might need to lower property prices to attract buyers with reduced disposable income. However, holding onto property longer allows you to avoid selling during these downturns.
Including real estate in your investment portfolio can help offset losses from other assets more susceptible to inflation, like stocks and bonds. Home prices typically outpace inflation, rising even during economic downturns. Additionally, rental income from real estate investments tends to keep pace with inflation, providing investors with a steady stream of passive income regardless of economic conditions.
The Impact of Inflation on Real Estate Construction Costs
During periods of high inflation, construction materials become more expensive, leading to higher costs for building new homes and remodelling existing ones.
Builders are often hesitant to initiate new construction projects when inflation is high. This reluctance can drive up the value of existing properties due to reduced inventory.
However, if high interest rates cause new homes to remain unsold for extended periods, builders may need to lower their prices. This reduction can affect the value of other properties in the area. If comparable homes in your neighbourhood decrease in price, your property’s market value may also decline.
New construction projects typically require borrowing money, and high interest rates can discourage builders from taking on new projects. While this can increase the prices of existing homes due to lower inventory, it can also contribute to overall inflation. Although this may not directly impact the real estate you currently own, it could make acquiring new properties more difficult.
The Effects of Inflation on Real Estate Investments
Inflation impacts more than just rental properties; it also significantly affects commercial real estate.
During high inflation, business owners who rent or lease commercial spaces face increased operating costs and potential rent hikes. Owners of commercial buildings may experience higher vacancy rates if businesses downsize or close due to unaffordable costs.
Additionally, the cost of materials for repairing commercial buildings rises with inflation. Delaying repairs in hopes of lower inflation can lead to disrepair, reducing the property’s value. Conversely, reduced new commercial construction can increase the value of existing buildings due to limited supply.
Benefits of Real Estate Investing During Inflation
Investing in real estate during inflation offers several benefits, despite higher interest rates and stricter lending requirements. One key advantage is the ability to build equity in an investment property shortly after purchase. While property prices fluctuate, they tend to increase over time. Therefore, buying property sooner is generally advantageous, especially for long-term investments.
Another reason to invest in real estate is the potential for further interest rate increases. As interest rates rise, housing becomes less affordable. However, you can refinance your high-interest mortgage if rates decrease in the future, all while building equity with each payment.
Additionally, rent often rises with inflation, increasing your passive income from rental properties. The demand for rental housing typically grows during inflationary periods, as prospective buyers struggle to obtain loans or are deterred by high mortgage interest rates. This scenario presents a valuable opportunity for investors with the capital to acquire property during high inflation.
Final Thoughts
Inflation leads to higher costs for goods and services, while incomes often lag behind. This economic shift significantly affects real estate investors. Rising interest rates can make mortgages less accessible, and a reduced supply of properties limits investment opportunities.
However, there are positive aspects. Real estate investors can benefit from higher rents, leading to increased cash flow. Additionally, a diversified portfolio that includes real estate can help mitigate losses, as property values generally rise during inflation.
