How Does Inflation Affect Real Estate? Here's What You Need to Know. With so much speculation regarding the forecast of America's economy and how inflation rates will change, those in the property market need to know how inflation can affect the real estate sector.
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With so much speculation regarding the forecast of America's economy and how inflation rates will change, those in the property market need to know how inflation can affect the real estate sector.
Of course, passive income from an investment is always the goal, and the property market has always been known to be a prime market for investors. Still, the recent surges in inflation cause many would-be property investors to second-guess their next move.
The good news is that, overall, inflationary times can present excellent investment opportunities in real estate, as this article will reveal. So, exactly what is inflation, how can it affect real estate and should it deter investors?
What is inflation?
Inflation relates to an increase in the average prices of a particular economy's goods and services over a set period of time. Another way to look at inflation is as a reflection of the decrease in the dollar's purchasing power (or another currency unit).
As an example of how inflation affects goods and services — with an average rate of inflation of 2% — the $600 fridge purchased last year would now cost an additional $12 if bought new today. This may not seem like a significant difference, but when you factor in an increase in inflation across all purchases made, the extra expenses start to stack up.
From a real estate perspective, inflation can impact the property market in a range of ways, which we will discuss throughout this article. Still, for the purposes of defining inflation as a basic concept, the same would apply. A property that might have cost $400,000 a year ago may now cost $450,000, despite no actual value-adding changes being made.
Is inflation the same as appreciation?
No. An appreciation rate, such as in the case of real estate, relates to the amount a property's value increases over time. When a property's value appreciates, it is increasing in response to market demand, not the power of the dollar.
Therefore, real estate can sometimes appreciate more than the rate of inflation, and sometimes it can depreciate despite an inflationary economy.
Federal Reserve prioritizes inflation cooling
On July 27, Federal Reserve chairman Jerome Powell increased short-term rates by 75 base points. This was the second consecutive hike of 75 basis points in a bid to cool inflation, which exceeded 9% in June — the highest it's been in 40 years.
This increase will primarily affect the cost of borrowing when it comes to financing, such as car loans, credit cards and adjustable-rate mortgages. Mortgage rates have been rising in line with inflation. A 30-year fixed rate mortgage is now in the region of 5-6%.
How does inflation affect real estate?
How inflation affects the business of real estate is a mixed bag. Here is a breakdown of what can typically be expected:
Increased cost of borrowing
Inflationary times inevitably lead to increased costs involved in borrowing funds. To protect their profits, banks will increase the interest rates for borrowers and tighten their underwriting, thus offering fewer loans to mitigate risk.
New build plans can suffer
As well as higher borrowing costs, inflation forces the costs of building materials, labor and machinery up, making it a tricky time for new construction investment.
Increased rental property rates
In periods of high inflation, it can be harder than ever for consumers to secure affordable mortgage terms. As a result, many have no choice but to continue to rent, keeping demand high and competition fierce.
As more renters flood the market and the cost of construction stalls new housing developments, a slump in inventory creates even more demand, further pushing rent prices up. Depending on borrowing costs and financial circumstances, periods of high inflation can be a great time to be a landlord.
Property values typically appreciate
The greater the demand, the more property is worth. In inflationary times, fewer new builds and other development plans can get off the ground due to rising costs of construction-related products and services.
This leads to plummeting property inventory levels, keeping demand ratios high and thus increasing prices. This often leads to potential buyers being priced out of buying a property and can also spur affordability migration.
Vacation rentals tend to suffer
When the population has to adapt to rising costs and budget accordingly, travel is usually one of the first luxuries to get shelved. Consequently, vacation rentals, especially in locations highly dependent upon the tourist trade, can suffer void periods and low demand.
In addition, communities that specialize in retirement living can also be impacted as many would-be buyers choose to ride out the economic instability before making the transition.
Real estate as a hedge against inflation
Investors commonly purchase tangible assets such as real estate to hedge against inflation. Other investments, such as stocks, typically react negatively to rising inflation, but property responds proportionally, often increasing in value as inflation creeps up.
Certainly, anyone with a low-interest rate locked in on a property will likely benefit from appreciation while expenses remain the same.
Inflation reduces the relative cost of historical debt
If wages increase in line with inflation and a borrower has debt that was accrued before the inflation rise, the inflation rise can benefit the borrower. The borrower still owes the same dollar amount back, only now they have more money in their wages to pay it off. In other words, inflation allows debtors to repay lenders with money that is worth less than when it was originally borrowed.
Inflation causes the worth of a unit of currency to decline over time and depending on your circumstances, this can work in your favor — it's not all doom and gloom.
The bottom line
Rising rates of inflation can have differing impacts on the real estate sector. It can be tough to enter the property market, agents can have a harder time finding buyers and renters can struggle to find affordable options. Conversely, landlords unburdened by rising borrowing costs will be sitting pretty.
Interest rate hikes, coupled with pandemic-driven price increases, are currently causing some affordability issues in markets that have recently experienced significant growth. While this is cooling the demand in some of these markets, the continued lack of property inventory is serving to minimize the extent to which values will drop.
Overall, one of the reasons that investors favor real estate is due to its staunch ability to weather the pressures of rising inflation and emerge with its values intact, even improved.