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The effect of inflation on real estate investors

The role of inflation on real estate investors
by Brad Cartier, posted in Investment Strategy

With inflation appearing on the horizon, many real estate investors are wondering what this means for their assets and business. With the rise of inflation, we see consumer prices increase, but what effect does this have on real estate?

Inflation has many real estate-related side effects, generally including higher mortgage rates, increasing asset prices, long-term debt gets devalued, construction gets more expensive, and more. Let’s take a closer look at the role of inflation on real estate assets, mortgages, and how investors can position themselves in a high-inflation environment.

Inflation can lead to higher mortgage rates

Generally speaking, as inflation increases, so too do interest rates. As inflation goes up, central banks typically raise short-term rates to put downward pressure on the inflationary environment.

If interest rates are low, more consumers tend to borrow which means they have more money to spend. This moves inflation higher. As central banks raise interest rates to fight off inflation, consumers will tend to save more rather than spend because returns from higher interest rates are more appealing. The hope is that with less consumer consumption, inflation will ease.

Bottom line: An inflationary environment usually sees higher mortgage rates.

Inflation can lead to higher asset prices

As this price of things increases with inflation, so too does real estate. Generally speaking, when inflation increases then housing and other real estate asset prices follow suit. That said, because we also see mortgage rates rise, this tends to put downward pressure on demand for real estate because debt becomes more expensive.

This can in turn put downward pressure on asset prices as demand decreases.

Inflation eats historical debt

Your existing debt becomes cheaper as inflation increases. Consider the following example:

  • 5 years ago you bought a property for $125,000 with a $25,000 downpayment.
  • You have a 25-year $100,000 mortgage at a 3% fixed interest rate.
  • Assume that inflation increases 3% every year following.
  • Each following year you’re still only paying $475, but the value of your money has gone up 3% every year.

Therefore, the relative cost of your debt goes down every time inflation hits.

Inflation causes construction costs to rise

Because things get more expensive with inflation, the cost of materials used in construction will also rise. There’s a lot that goes into real estate development, and all of those prices will generally increase as inflation creeps in.

It is widely understood that inflation increases wages, machinery costs, and building materials. It also puts developers and investors in a scenario where cost-overruns are much more possible. If you planned a build several years ago in an inflationary environment, your costing will need to account for the inflation of all the building materials and labor.

Residential outperforms during inflationary periods

The good news for investors with single-family homes (SFHs), condos, and multifamily in their portfolios is that these asset classes tend to outperform in inflationary environments.

According to a Standford University study, residential real estate is historically an investment safe-haven during inflationary periods. In the study, they found that with the inflation of the 1970s, home prices increased relative to the size of the economy.

The WSJ points this out more eloquently, “Owners of residential and commercial real estate are often better off during times of rapid inflation than owners of stocks or bonds, economists say. Office, retail and apartment rents are typically tied to consumer prices and rise with inflation, pushing up property income. Inflation also makes construction more expensive, which benefits property owners because they can expect less competition from new buildings.”

Risk: The risk for investors is not regularly increasing rents to keep up with inflation, or to prepare for higher than expected inflationary pressures. Just think about it, if inflation rises 3% every year and you don’t raise rents, you’re taking a loss that is compounded over time.

Rents

Studies have shown that historically high periods of inflation also saw a similar increase in rent prices. According to a recent study, during the high-inflation period from 1973 to 1983,

“Rents grew slightly less than overall inflation but slightly more than core inflation stripped of food and energy…Finally, the American Housing Survey shows that the median rent increased by an average annual rate of 8.5%, which exceeds all measures of inflation.”

Inflation and real estate: A hedge?

Given that under most circumstances an inflationary environment leads to higher rents and higher asset prices, real estate is considered to be a great hedge against inflation. This is due to three general phenomenon:

  1. Rents rise with inflation
  2. The value of your property rises with inflation
  3. The debt on your asset is devalued as the value of that debt decreases with

That said, investors need to be warry of high-inflation environments, primarily because the cost of borrowing will increase, putting downward pressure on your cash flows and demand for real estate if you want to liquidate. It also makes new real estate development more costly.

With more positives than drawbacks, an inflationary environment can be positive for real estate investors if they make smart acquisitions and stress test their portfolio again inflationary pressures such as rising interest rates.