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With so much speculation about predicting America’s economy and how inflation rates will change, those in the real estate market need to know how inflation can affect the real estate sector.
Passive income from an investment is of course always the goal, and the real estate market has always been known to be a prime market for investors. Still, the recent spikes in inflation have many prospective property investors second-guessing their next move.
The good news is that inflationary times can generally provide excellent real estate investment opportunities, as this article will reveal. So, what exactly is inflation, how can it affect real estate and should it scare off 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 decline in the dollar’s (or another currency’s) purchasing power.
As an example of how inflation affects goods and services—with an average inflation rate of 2%—the $600 refrigerator purchased last year would now cost an additional $12 if purchased 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 add up.
From a real estate perspective, inflation can affect the real estate market in a variety of ways, which we will discuss throughout this article. Yet, for the purposes of defining inflation as a basic concept, the same will apply. A property that might have cost $400,000 a year ago may now cost $450,000, despite no real value-adding changes being made.
Is inflation the same as appreciation?
No. An appreciation rate, 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 increases in response to market demand, not the strength of the dollar.
Therefore, property 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 raised short-term rates by 75 basis points. It was the second consecutive increase of 75 basis points in an attempt to cool inflation, which exceeded 9% in June – the highest it had been in 40 years.
This increase will mainly affect the cost of loans when it comes to financing, such as car loans, credit cards and adjustable rate mortgages. Mortgage rates have risen in line with inflation. A 30 year fixed rate mortgage is now in the region of 5-6%.
Related: Mortgage rates above 6 percent for first time since 2008
How does inflation affect real estate?
How inflation affects the business of real estate is a mixed bag. Here’s a breakdown of what can typically be expected:
Increased cost of borrowing
Inflationary times inevitably lead to increased costs associated with borrowing funds. To protect their profits, banks will raise interest rates for borrowers and tighten their underwriting, thereby offering fewer loans to reduce risk.
New building plans may suffer
As well as higher borrowing costs, inflation drives up the cost of building materials, labor and machinery, making it a difficult time for new construction investment.
Increased rates for rental property
In periods of high inflation, it can be more difficult than ever for consumers to secure affordable mortgage terms. As a result, many have no choice but to continue renting, keeping demand high and punishing competition.
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 up rental prices. Depending on borrowing costs and financial circumstances, periods of high inflation can be a good time to be a landlord.
Related: Mortgage rates hit a 16-year high of 6.75%. Here’s what it means for the industry.
Property values typically appreciate
The greater the demand, the more property is worth. In inflationary times, fewer new buildings and other development plans can get off the ground due to rising costs of construction-related products and services.
This leads to falling property inventory levels, which keeps demand ratios high and thus increases prices. This often leads to potential buyers not buying a property and can also spur affordability migration.
Vacation rentals tend to suffer
When the population has to adjust to rising costs and budget accordingly, travel is usually one of the first luxuries to be cut. As a result, vacation rentals, especially in places that are highly dependent on the tourist trade, can suffer from empty periods and low demand.
In addition, communities that specialize in retirement living may also be affected, as many prospective buyers choose to ride out the economic instability before making the transition.
Real estate as a hedge against inflation
Investors usually buy tangible assets such as real estate to hedge against inflation. Other investments, such as stocks, typically respond negatively to rising inflation, but real estate responds proportionately and often increases in value as inflation creeps up.
Certainly, anyone with a low interest rate locked into a property is likely to benefit from appreciation while expenses remain the same.
Inflation reduces the relative cost of historical debt
If wages rise in line with inflation and a borrower has debt that accrued before the rise in inflation, the rise in inflation may 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 value of a currency to fall over time and depending on your circumstances, it can work in your favor — it’s not all doom and gloom.
Related: Inflation is a risk to your business, but doesn’t have to spell doom
The bottom line
Rising inflation rates can have different impacts on the real estate sector. It can be difficult to enter the property market, agents can have a harder time finding buyers and tenants can struggle to find affordable options. Conversely, landlords relieved by rising borrowing costs will sit pretty.
Interest rate hikes, along with pandemic-driven price increases, are currently causing some affordability issues in markets that have seen significant growth recently. While this cools demand in some of these markets, the continued lack of real estate inventory serves to reduce the extent to which values will decline.
In general, one of the reasons investors favor real estate is because of its strong ability to withstand the pressures of rising inflation and emerge with its values intact, even enhanced.