What Does Inflation Do To Real Estate?

Among the biggest concerns of real estate investors are inflation and its potential impact on their assets and businesses in the long run. Inflation leads to higher consumer prices, but how does it affect real estate?

Real-estate inflation has many side effects that influence the market, including a rise in mortgage rates, an increase in asset prices, a reduction in long-term debt values, a rise in construction costs, and many more. Before delving into the details, it’s essential to understand how exactly inflation works.

How Does Inflation Work?

In a nutshell, inflation is the gradual increase in the price of goods and services in a given market that is, in essence, a rise in the cost of living. As a result of the rising price level, each currency unit will buy fewer items and services.

Thus, inflation is defined as a loss of purchasing power caused by a loss of money. It is a common measure of inflation to use the inflation rate — the annualized percentage change in an index of general prices — on an annual basis.

Inflation in Real Estate

Real estate has historically been considered to be one of the most effective inflation hedges in the world. In the United States, there was a 13.5% rise in the consumer price index (CPI) in 1979, which was the highest level since 1947, according to research done at The Wharton School of the University of Pennsylvania.

The yield on dividends from real estate investment trust (REITs) trading on the stock exchange that year was currently 21.2%, approximately the average for REITs trading in that industry. The annualized inflation rate for the first eight months of 2011 was also 5.1% as a result of the annualized rise in consumer prices.

In addition to an average annualized total return of 8.4% in this time period, REIT returns provide strong protection to the purchasing power of investors.

How Inflation Affects Real Estate

It is estimated that in the last ten years, American inflation has put the value of a single-family home in an average middle-price tier has risen by more than 90%. According to the housing market report for the year ahead, the price of a home will increase by 13.6%.

Generating Higher Asset Prices

During periods of high inflation, real estate ownership offers many benefits. With inflation keeping pace with property values, owners will see their properties appreciate. In addition, as a result of rising labor, material, machinery, and other costs, there are fewer projects for real estate development, which in turn leads to a slump in property supply, hence an increase in prices.

When inflation increases, the price of real estate rises because investors seek assets that generate yields above and beyond inflation rates, which is one of the reasons why real estate prices rise during inflationary times.

Increasing Rent Prices

Rent collected from tenants is used to pay operating expenses, property taxes, and mortgage payments. The return on investment at the end of each period is expressed as a capitalization (cap) rate, which refers to any remaining money at the end of the period. By dividing the net operating income of a property by the price of the property, the cap rate of a property can be determined.

Prices are driven upwards by inflation, and rents are no exception. The occupancy rate of existing properties usually skyrockets as the pace of housing construction slows and the demand for existing properties increases.

As a result, landlords can raise rents, which generates higher revenue for them and will therefore increase the value of their properties. In September 2021, the number of Americans renting homes increased by 10.2% over the same period last year. 

Dwindling Supply of Real Estate

The availability of property is also a contributing factor to why the price of real estate tends to rise with inflation because there are fewer properties than there are fiat units of currency. Due to the increased printing of money, it is expected that real estate prices will rise as the money supply increases.

Rising Costs of Housing Constructions

Increasing wages and the cost of materials, supplies, and land also contribute to inflation, driving up the cost of building a home. In turn, home builders pass on the cost of building a new home to home buyers and real estate investors, which is another reason why real estate prices have been rising. 

Rising Mortgage Rates

In general, a rise in inflation will also increase interest rates. It is common for central banks to raise short-term interest rates when inflation rises to reduce the inflationary pressure on the economy. Low-interest rates lead to more consumers borrowing, which means more money than they can spend over the course of the year.

As a result, inflation begins to rise. A significant increase in interest rates by central banks as a measure of fighting inflation may lead consumers to save more rather than spend more, as the returns of higher interest rates will be more attractive. Inflation is expected to ease as a result of less consumer consumption as a result of lower consumer prices.

However, it is essential for advisors and investors to understand that during inflationary periods if mortgage rates rise, the demand for real estate tends to decrease due to a higher cost of borrowing. As a result, asset prices may suffer from adverse effects due to a weakening of demand.

Is Real Estate an Inflation Hedge?

It is widely considered that real estate is an inflation hedge because an inflationary environment typically leads to more expensive rents and asset prices. A high inflation environment poses a threat to investors since the cost of borrowing will rise, reducing cash flow and the demand for real estate when you sell.

Real estate development also becomes more expensive because of it. Inflationary conditions can have more positives than negatives for real estate investors who do their due diligence and put their portfolios at risk of inflationary pressures.

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