Real estate Is often said to be a good hedge against inflation. As an investor, it’s one way that you can protect your portfolio. If you’re considering buying a property, keep reading to learn what you need to know about inflation and real estate investing.
We will walk you through an overview of what inflation is, why it occurs, and how it affects real estate investments. Armed with this knowledge, you’ll have a much better idea of whether or not investing in real estate is the right move for you and your portfolio.
What Is Inflation?
Before getting into any specifics about investing in real estate during inflation, it’s important to make sure that you have a firm grasp of the concept of inflation and its broader effect on the economy.
Put simply, the term “inflation” refers to a loss of purchasing power over time. When inflation occurs, the price of goods rises, meaning that your money is not able to stretch as far as it did in the past.
As a rule of thumb, the Federal Reserve – the central bank of the United States – aims for a target rate of about 2% inflation per year. However, in economic downturns and times of uncertainty, the rate of inflation is often much higher.
According to figures from the Bureau of Labor Statistics, as of February 2022, the price of goods has increased at a rate of 7.9% in a 12-month period. While the costs of energy and food have increased the most, the prices of other goods and services have gone up as well.
Real estate investors only have to look at average sale price data to see that inflation is clearly having an effect on property values.
What’s Causing Inflation in 2022?
Now that you understand a little bit more about how inflation works and where we currently stand, the next step is to take a closer look at some of the major causes behind these broad increases in price.
While costs generally tend to increase over time, in the short term, higher-than-average inflation rates can be due to a variety of factors. Here are just a few of the things that have contributed to the current spike in inflation.
Any time new money is printed, it increases the overall supply of money in the economy and decreases the value of each individual dollar. At the beginning of the pandemic, the Trump Administration passed a $5 trillion stimulus package.
While those stimulus checks put some much-needed money in the hands of Americans during a period of widespread unemployment, they also undoubtedly added more money to the economy. There’s a good chance that we’re seeing the effects of that decision now.
International conflict can be a huge contributing factor to inflation. Currently, the Russian-Ukraine conflict is increasing the cost of goods like oil significantly. As a rule of thumb. for every $10 increase in crude oil raises inflation by 0.2% – 0.4% as a direct correlation.
Some investment banks have estimated oil to reach as high as $200 per barrel if the Russian supply continues to dissipate.
Supply and Demand Problems
Then, there’s the issue of supply and demand. When the supply of a good is low, prices tend to increase because there is more demand for each individual item available. In real estate, the supply and demand issue has a few different causes.
To start, the widespread shutdown of businesses at the beginning of the pandemic has obviously had an effect on the global supply chain. The lumber shortage is just one example of affecting the real estate industry.
Still, other goods that may be of interest to real estate investors, like appliances, have also been subject to similar issues.
However, in addition, some of the problems that we’re having with housing inventory can be attributed to decreased levels of construction following the 2008 financial crisis.
According to data from Realtor.com, the supply gap between household formations and newly constructed single-family homes now measures 5.8 million, which is up from 3.84 million in 2019.
Expectation of Inflation
Lastly, when businesses suspect that prices are about to rise, they tend to act accordingly. Often, they will make price increases or build a higher cost of goods into contract negotiations.
It is likely that many businesses took this route following the rollout of the stimulus package, which may have encouraged prices to start rising even before inflation rates began to increase in earnest.
How Does Inflation Affect Real Estate?
Once you have a clear grasp on what causes inflation, It’s time to get to the meat of the matter and learn about the effects that inflation has on real estate. In truth, it has both potential benefits and disadvantages.
With that in mind, we’ve laid them out below for your consideration. Take a closer look to see how the current spike in inflation rates might affect the Investments in your portfolio.
Cons of Inflation for the Real Estate Market
1. Borrowing Costs Increase During Inflation
One of the Fed’s most effective tools against inflation is raising interest rates. After all, higher interest rates deter spending and less spending eventually leads to lowered demand and a drop in prices.
To that end, it shouldn’t be a surprise that interest rates have started to climb. As of the time of writing, The current average interest rate on a 30-year fixed-rate mortgage sits at 4.67%, which is an increase from 4.42% a week prior and 3.18% a year ago.
What’s more, rates are only going to keep going up. At their most recent meeting in March 2022 policymakers at The Federal Reserve approved a 0.25% rate hike, the first since 2018.
However, they also signaled that there will be more rate hikes to come. While nothing is set in stone, officials are forecasting around six more before the end of the year.
As an investor, these rate increases mean that you will have to budget for an increased borrowing cost and that your overall purchasing power will be lower. However, it’s also crucial to look at the big picture.
Rates are still at historic lows and, once you lock in a rate, you’re essentially hedging your bets against future increases.
2. Costs of Renovations Increase as Well
That said, once you complete the transaction, you may face more inflated costs, especially if you’re planning on doing renovations. On the whole, according to data from the National Association of Homebuilders (NAHB), the cost of building a home has risen 31.3% since January 2020. Additionally, 10.5% of that increase occurred within the last five months.
The NAHB report also looks at the increases in pricing for some common building materials. Here’s a closer look at some of the highlights:
- Softwood lumber: Up 79% since September 2021
- Steel mill products: Up 74% from February 2021
- Exterior paint: Up 30% since February 2021
- Interior paint: Up 21% since February 2021
- Gypsum products: Up 20% from February 2021
- Ready-mix concrete: Up 8.2% from February 2021
Pros of Inflation for the Real Estate Market
1. Home Prices Rise With Inflation Rates
You’ve probably heard the saying “real estate is a good hedge against inflation.” For the most part, it’s true. While those rising material costs are a negative when you’re thinking of doing renovations, if you own turn-key properties, they may be to your advantage.
In this case, since the cost of building materials is so high, potential buyers are less likely to choose new construction. As a result, there is increased demand for existing properties, which drives sale prices higher.
The National Association of Realtors (NAR) found that the national median home price rose 14.6% over the last year, to a price of $361,700.
2. Rents Increase Alongside Home Prices
In addition to increases in property values, buy-and-hold real estate investors will also be pleased to know that rents have a tendency to increase during periods of high inflation. As home values go up, so does the amount that a landlord can charge a tenant to reside in the property.
According to Rent.com data from March 2022, on a national level, rent for a one-bedroom apartment increased 24.4% year over year. Rents for two-bedroom units showed slightly less growth at 21.8%
If you can increase your rent beyond the amount that you pay each month for your mortgage, you may be able to capitalize on inflation and put some extra money in your pocket. After all, while rates can rise over time, your mortgage amount stays the same.
3. Real Estate Outperforms Cash Investments During Inflation
Some investments, especially those typically held for shorter periods of time, such as stocks, CDs, or treasury bills tend to fare poorly when inflation rates start to rise. Since cash investments tend to have a shorter investment horizon, they can be more volatile or subject to fluctuation.
Real estate, on the other hand, does not have the same amount of volatility. Historically, it tends to be a long-term investment and property values tend to trend on an upward curve over time.
Is Real Estate a Good Investment During Inflation?
At the end of the day, real estate investments provide good protection against inflation. While there are advantages and disadvantages to every investment scenario, in this case, the pros outweigh the cons.
Ultimately, it’s an asset that can withstand economic changes like inflation. If you’re looking for a way to hedge against inflation and to diversify your portfolio, it’s likely a good idea to consider adding an investment property into the mix.
If you’re ready to take the next step towards owning your own investment property, the team at New Western can help. Our professionals can help you find exclusive, off-market deals and we’ll also help you analyze the numbers so you know if the deal is right for you.