Inflation is a common phenomenon in most economies. In fact, it is often seen as an early sign of the end of an economic cycle. Naturally, a sudden spike in inflation can have a seismic impact on a wide range of sectors and investment portfolios, and investors who fail to navigate it will invariably be wiped out. But how does real instate investing fare against inflation? What happens to real estate during inflation? And is inflation good for real estate? This article will answer all these questions and make the case for why real estate assets are the ideal inflation protection.
What Is Inflation?
Before delving into the questions above, we must first define what inflation is. In simple terms, it is an increase in the price of goods and services over a certain period of time. There are several reasons why inflation occurs in a particular market. The main ones are excess aggregate demand and cost-push factors. A good example of the former is a spike in demand for certain products and services. As for the latter, an increase in wages, production expenses, and the cost of raw materials will often lead to a high rate of inflation.
Now that you know what inflation is, let’s examine how it affects the real estate market.
How Does Inflation Affect the Real Estate Market?
Like we mentioned above, inflation has a sizable impact on a myriad of sectors. The most affected ones being the financial, energy, and utility markets. But in stark contrast to these industries, real estate investors rarely feel the brunt of this impact. So how does real estate hedge against inflation? Below is an in-depth look at how the housing market reacts to rising prices and what makes a real estate investment such an inflation-proof asset.
1- Property values will increase
As you would expect, real estate prices will also increase when a high inflation rate hits the economy. The reasons for this are quite obvious and simple. Since the prices of construction materials will be high, developers will spend more when building new properties. This will lead to an inevitable increase in the price of new real estate properties. Moreover, existing properties will also rise in value due to the reduced supply of new constructions.
2- The cost of borrowing will be higher
Generally speaking, an economy that is experiencing rising prices is not conducive to getting favorable loan terms. In fact, the cost of borrowing tends to be quite high in these situations. The fact that inflation devalues the currency forces most lenders to raise interest rates. This is usually done in an effort to cover the losses that are engendered by the decrease in currency value. It is also worth noting that this higher cost of borrowing affects both buyers and real estate developers. As a matter of fact, most construction companies rely on loans to tackle their projects and an increase in interest rates will invariably result in higher property prices.
3- Rental rates will soar
The increase in rental rates is one of the most noticeable effects of inflation. Due to the high cost that comes with mortgages, most people will opt to rent rather than buy. The high demand for rental properties and the influx of tenants will prompt landlords to raise their rental rates. Needless to say, owning a rental property in this economic climate places you in an ideal position as tenants are more willing to pay higher rents than take on an unmanageable mortgage.
So what does all this mean for people who own investment properties? And how to profit from inflation as a real estate investor? The next section will focus on these two points in more detail.
How Does an Investment Property Provide a Hedge Against Inflation?
While inflation is not good for real estate per se, it does offer some decent opportunities to investors. There are several factors that make investment properties the ideal asset during inflation. Here are the main ones.
1- Appreciation offsets inflation
Real estate appreciation is a highly effective hedge against rising prices. In fact, the appreciation rate of US real estate has been consistently higher than inflation for over a decade now. While this approach might not be capable of yielding high returns when prices spike, it will definitely protect your investment and net worth from the devaluing effects of inflation.
2- Rental properties generate high returns
Rental properties are without a doubt the most profitable assets during inflation. As more people steer away from loans and begin flocking to traditional rental properties, real estate investors will be able to capitalize on the trend by charging more for rent. The high rental income coupled with the low vacancy rates will help generate a very high return on investment for landlords. More importantly, investors who have a fixed-rate mortgage can put this high income toward servicing their debt in a quick and efficient manner.
Other Ways to Profit from the Housing Market When Prices Rise
As most versatile real estate investors know, buying an investment property is not the only way to profit during inflation. Below are a few examples of how you can do so without acquiring a physical asset.
Invest in real estate investment trusts (REIT).
Join a real estate crowdfunding platform.
Invest in a private equity fund that specializes in real estate investments.
Invest in a mutual fund that focuses on the housing market.
Real Estate Inflation: The Bottom Line
Given the ongoing economic situation, the return of inflation seems inevitable. Understanding the mechanisms of this phenomenon is necessary for navigating a market that will soon feel the effects of rising prices