How Does Inflation Affect Real Estate?

Jan 18, 2022

How Does Inflation Affect Real Estate?

2021 has been the year of aggressive inflation. Money is moving around like wildfire as the economy strengthens and stabilizes. Price tags across businesses keep getting steeper everywhere we turn, including the price to own or rent a home.
The real estate market continues to be the talk of the town, even though inflation stands its ground. The value of a home and the rental rates tend to stay neck and neck in the race with inflation.
In fact, the real estate market can be considered a driver.

What Is Inflation?

Inflation is an economic concept with a straight-to-the-point definition that becomes complicated when applied to the economy. The simple definition: the measurement of rising cost of goods and services over a period of time. This includes costs associated with gas, clothing, food, and of course real estate.

Inflation or Appreciation

It is important to point out that inflation and appreciation are two different concepts.
Appreciation focuses on the value of a property over time based on demand. It doesn’t necessarily dictate the price or the cost.
Having a property that appreciates over time means that it is desirable on the market, drawing the attention of potential buyers due to its location, its offerings, etc.
Sounds similar to inflation, right? The difference focuses on the purchasing power. Over time, the value of the dollar decreases, affecting cost of living.
In a perfect world, both appreciation and inflation should keep up with one another. This does not happen all the time.

Contributors to Inflation

Three types of inflation can impact the economy: demand-pull, cost-push, and built-in inflation.
We see demand-pull inflation most commonly as increased money pours into the economy. This could be from an increase in employment, government stimulus payments, and even the introduction of low interest rates.
As more people are spending, there is an overall increase in the demand for goods and services. Prices begin to rise because businesses can not keep up with the production and supply of products and services.
With cost-push inflation, increased labor and supplies drive high production costs. For example, this may be why you see extreme prices at the gas pump while fueling your car.
Built-in inflation stems from the idea that inflation rates are set to recur in future years. Employees begin to demand an increase in pay due to the rising costs of goods and services. When granted, the increase in wages results in a continued upward spiral of increased prices since both are dependent upon each other.
These types of inflation play a role in a dynamic economy such as ours.

Consumer Price Index, or CPI

The consumer price index is in place to measure the prices of goods and services consumed in households. The consumer price index is a strong indicator of inflation, and the housing segment plays a vital role.
A shelter component is configured into the index, making up 1/3 of the pie for inflation. There is a slight drawback, though, as the housing industry is made up of two components: rental properties and owned housing.
Rental properties require no further thought. There is a set monthly payment made by the tenant. That’s it. On the other hand, owned housing is not a consumption metric. It is an investment, just like a stock or a mutual fund.
It’s not realistic to ask homeowners what they would receive in rent; their property isn’t on the market. That’s why the Home Price Index (HPI) is factored in.
The HPI records the changes in the value of homes, whereas the CPI can not.

Does Inflation Pose Consequences on the Real Estate Market?

The entire world has seen the effects of rising inflation, including the real estate market.

Construction Costs for New Homes

The shortages are everywhere, including building supplies and labor. The effects on new construction homes include:
  • Delays in construction, leading to further demand in the housing industry
  • Listing price increases to cover the cost of materials and wages
According to The White House, lumber costs increased an average of 114% in 2021. Iron and steel trailed behind, increasing approximately 73%. A shortage of skilled construction workers that would handle the framing, electrical, plumbing, and more also delays building new homes. Increased costs are later passed down to the buyer, built into the cost of the home.

Purchase Price

Part of the listing price of a new-construction home relates to the construction costs we just touched on. The other focuses on the demand to buy.
There is a high demand for housing, but inventory remains low. It has been for years, but COVID jump-started the rush to own once more. When interest rates are at an all-time low, people notice and take advantage of it. A bonus is an introduction to working remotely. Why wouldn’t you move if you could work where you wanted and reside in an area you’ve always dreamed of?
Now introduce inflation. Interest rates begin to grow, making it more difficult for buyers to secure a mortgage. This leaves them to seek the alternative option, renting. People are also competitive, willing to pay more than the asking price to secure a new home.
That’s why some homes during 2021 sold for greater than the listing price. Remember, the greater the purchase price when borrowing from a mortgage lender, the larger down payment you’ll be required to make.

Cash Offer Versus Mortgage Lender

During the process of buying a home, an appraisal is typically performed.
Its purpose? To have an unbiased professional value the home. This is a mandatory process for buyers working with a lender to finance their purchase.
Mortgage lenders will decline a loan if an appraisal is less than the purchase price. They want to ensure that the asset is backed by equity if future losses occur. But if you are a cash-paying buyer, you can bypass this process.
Cash buying is hot off the press and becoming more popular during inflation. This leads to competitive bids on purchase prices, exceeding the asking price and most likely the appraisal offer.

Are There Benefits to Inflation with Real Estate?

Buying a house can be considered a hedge against inflation. This means that by purchasing a home, you are seeking to protect yourself from the decreased value of other investments that occur with rising prices.
Real estate can be a strong investment. It holds its value and typically increases over time. Here are a few options for you to consider:
  • Buying into a rental property
  • Mortgage note investing
  • Real Estate Investment Trusts, or REIT
  • Historical debt thins out

Rental Property

As housing prices increase and banks begin to introduce higher interest rates, the buyer’s market depletes as housing is no longer affordable. That’s when the demand may pick up in the rental market, and where you might build an investment.
Rental property can be commercial or residential. The choice is yours, but research the location and potential for demand. A prime area, such as one with a low vacancy rate, could mean a faster return on your investment.
Think about it. To keep up with inflation each year, rent is re-evaluated and usually increases alongside it. That’s why rental properties are considered one of the most profitable asset types during a time of inflation.

Mortgage Note Investing

We believe this option is a hidden gem. It’s rarely talked about but can be a strong investment option. There is no property manager or landlord involved. Instead, a promissory note is issued, and the homeowner makes their payment directly to the investor.
Ready for the advantages? Mortgage notes:
  • May have high yield returns
  • May be a great source of monthly income
  • Can be transferred to your IRA

Real Estate Investment Trusts

This is an option if you prefer not to purchase physical real estate. REITs are handled through brokerage companies and follow the demand of the market.
They are tradeable on the stock exchange, too. REITs are distributed across assets in your financial portfolio, helping to provide competitive returns through dividends and capital appreciation.

The Bottom Line

There are positives and negatives during an inflationary time for real estate. For investors like yourself, interest rates will likely increase, giving you a decreased purchasing power.
But a roof over one’s head is a necessity, so the rental side of the business becomes popular. Consider investing in real estate, if you have the funds, during a time of inflation.
If you have the desire to purchase your own home, save for your child’s future, or build a strategic plan for your retirement, it’s important to get started earlier and with the right type of investments.
LifeGoal Investments offers ETF options designed to give you the long-term growth you deserve.
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