Inflation broadly impacts the overall economy, causing the prices of goods and services to rise. This can have rippling effects across various sectors, including the real estate market.
Real estate investors, homebuyers, and home sellers need to understand how inflation impacts the real estate market. This can help them make the best decisions when buying and selling real estate.
We’re here to explain what causes inflation, its impact on real estate, and how real estate investors can benefit even when inflation is high.
Understanding Inflation and Its Causes
When your dollars don’t buy as much as they did in the past, it’s because of inflation. An increase in the money supply and debt is the ultimate culprit of high inflation.
Over the years, the central bank has significantly increased the money supply. Because of this, there are more dollars to go around. Ultimately, this means companies selling goods and services can charge more for them, as people technically have more money to spend, although incomes usually stagnate for inflation to happen.
An economy that isn’t growing, or at least isn’t keeping pace with the growth in the money supply, results in inflation. Companies can’t necessarily produce enough goods to keep up with demand, allowing them to charge more for what they can produce.
To keep inflation in check, the Federal Reserve often increases interest rates. This can help reduce consumer spending and lower rampant inflation.
As people spend and borrow less, companies can replenish and build up supplies. However, it can take several years for the economy to neutralize or grow after a period of high inflation.
What Happens to Real Estate During Inflation?
For real estate, inflation typically means you’ll pay more for a home. Your dollars aren’t worth the same amount today as they were last year. So a house that cost $400,000 a year ago could cost $450,000 today. If interest rates are also high, this means a significant increase in what you pay for a property.
On the other hand, if you already own property, you could see higher equity during periods of high inflation. While equity is good for your bottom line, inflation can be challenging if you want to add assets to your real estate portfolio.
Real estate as an inflation hedge
Many real estate investors will tell you real estate is a good hedge against inflation. The reason for this is often because of rising interest rates.
Let’s say you buy a home when interest rates are at 5%, and two years later, interest rates go up to 7% because of inflation. In this case, the mortgage you got with a 5% fixed interest rate is going to have a lower payment than if you get a mortgage with a 7% fixed interest rate. A higher interest rate, combined with a higher purchase price, makes real estate less affordable.
You might have to hold real estate long term if you want to use it as a hedge against inflation. Often, a volatile real estate market can create short-term corrections that affect the price of real estate. This may quickly change the value of a property.
Because people have less disposable income, investors might have to drop the price of their properties to make them more affordable. Being able to hold a property longer means you won’t have to sell if the market takes a downturn.
Having real estate in your investment portfolio can help mitigate losses from other assets that inflation affects more drastically, such as stocks and bonds. Because home prices usually outpace inflation, they tend to rise even when the economy is experiencing a rough patch. Rental income from real estate investments keeps up with inflation historically. This means investors can continue to receive passive income regardless of inflation.
Real estate construction costs and inflation
Construction materials cost more when inflation is high. This results in higher costs to build new homes and remodel or rehab existing homes.
Builders are less inclined to start new construction projects during periods of high inflation. Investors could see an increase in the price of their properties because of this. A property becomes more valuable when there’s less inventory available.
However, builders may have to reduce prices for new homes in their inventory if high interest rates keep them on the market too long. When prices for new homes fall, it affects other real estate in the area. If comparable homes in a neighborhood where you own property drop in price, it makes your home worth less to potential buyers.
New construction often requires builders to borrow money to complete the project. High interest rates can deter construction companies from building new homes. While this may drive up prices on existing homes, low housing inventory can fuel inflation. This may not affect the real estate you currently own, but it could make buying new properties more challenging.
Real estate investments and the effects of inflation
Rental property isn’t the only type of real estate inflation affects.
Commercial real estate is another area for investors to consider during times of high inflation. Business owners who rent or lease commercial space face an increase in operating costs. There’s also a higher potential for their rents to go up when inflation is on the rise. Those who own commercial buildings may see more vacant space if businesses have to downsize or close because they can’t afford to pay these higher costs.
It’s also important to consider the increased costs of materials for making repairs to a commercial building. If you put off making repairs while you wait for inflation to come down, you risk allowing your building to fall into disrepair, lowering its value. On the other hand, there may be a reduction in new construction for commercial buildings, which can increase the value of buildings that already exist.
Benefits of Real Estate Investing During Inflation
Despite higher interest rates and tighter lending requirements, investing in real estate during inflation has some benefits. For instance, you can build equity in an investment property soon after buying it. While the price of real estate varies, overall, it only goes up. So, in terms of real estate, buying sooner is always better, especially when you plan to hold it long term.
Another reason to invest in real estate is that interest rates could continue to rise. The higher interest rates climb, the less affordable housing gets. You can refinance your high-interest mortgage if interest rates come back down in the future. And you’ll have been building equity with each mortgage payment you make.
Rent often rises when inflation does, so you can increase your passive income by investing in real estate during inflation. Additionally, the demand for rental property tends to increase during times of inflation because borrowers have a harder time getting a loan or don’t want to pay the higher interest rate on their mortgage. This creates an excellent opportunity for investors who have the capital to buy property when inflation is high.
Inflation means the costs for goods and services are up compared to previous months, and incomes aren’t keeping up. What happens to real estate during inflation can have a big impact on investors. Increases in interest rates can make mortgages less accessible. A decrease in supply means fewer options when looking for investment opportunities.
But there’s a bright side. Real estate investors can take advantage of higher rents that result in an increase in cash flow. Plus, having a diversified portfolio that includes real estate can help mitigate losses, as real estate prices typically go up during inflation.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.