How does inflation affect real estate? Here’s what you need to know.

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With so much speculation regarding the forecast for the US economy and how inflation rates will change, those in the real estate market need to know how inflation may affect the real estate sector.

Of course, passive income from an investment is 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 potential real estate investors second-guessing their next move.

The good news is that overall, inflationary times can offer excellent real estate investment opportunities, as this article will reveal. So, what exactly is inflation, how can it affect real estate and should it deter investors?

What is inflation?

Inflation relates to an increase in the average prices of a particular economy’s goods and services over a particular period of time. Another way of looking at inflation is as a reflection of the decline in the purchasing power of the dollar (or another unit of currency).

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 pile up.

From a real estate perspective, inflation can affect the real estate market in a number of ways, which we will discuss throughout this article. Yet, to define inflation as a basic concept, the same would apply. A property that might have cost $400,000 a year ago may now cost $450,000, despite no actual value-adding changes being made.

Is inflation the same as appreciation?

No. An increase in value, for example in the case of real estate, is linked to the amount a property’s value increases over time. When a property’s value rises, it rises in response to market demand, not the power of the dollar.

Therefore, real estate can sometimes appreciate more than the rate of inflation, and sometimes it can fall despite an inflationary economy.

The Federal Reserve prioritizes cooling inflation

On July 27, central bank chairman Jerome Powell increased short-term interest rates by 75 basis points. This was the second consecutive increase of 75 basis points in an attempt to cool inflation, which exceeded 9% in June – the highest it has been in 40 years.

This increase will primarily affect loan costs when it comes to financing, such as car loans, credit cards and adjustable-rate mortgages. Mortgage interest rates have risen in line with inflation. A 30-year fixed-rate loan is now in the range of 5-6%.

Related: Mortgage rates are above 6 percent for the first time since 2008

How does inflation affect real estate?

How inflation affects the real estate business is a mixed bag. Here’s an overview of what can usually be expected:

Increased borrowing costs

Times of inflation inevitably lead to increased costs associated with borrowing funds. In order to protect profits, banks will raise interest rates for borrowers and tighten guarantees, thus offering fewer loans to reduce risk.

New construction plans may suffer

In addition to higher borrowing costs, inflation is driving up the costs of building materials, labor and machinery, making it a difficult time for new construction investment.

Increased rental prices

During 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, which keeps demand high and competition fierce.

As more renters flood the market and construction costs stall new housing developments, a decline in inventory creates even more demand, pushing rents up even further. Depending on borrowing costs and economic conditions, periods of high inflation can be a great time to be a landlord.

Related: Mortgage interest rates reached a 16-year high of 6.75%. Here’s what it means for the industry.

Property values ​​usually appreciate

The greater the demand, the more the property is worth. In times of inflation, fewer new buildings and other development plans can start due to rising costs for building-related products and services.

This causes the property stock to plummet, keeps the demand ratio high and thus increases prices. This often leads to potential buyers being priced out of buying a property and can also encourage affordable 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 shelved. Consequently, vacation rentals, especially in locations highly dependent on the tourism industry, can suffer from void periods and low demand.

In addition, communities that specialize in retirement may also be affected as many potential buyers choose to ride out the economic instability ahead of the transition.

Property as a hedge against inflation

Investors usually buy tangible assets such as real estate to hedge against inflation. Other investments, such as stocks, usually react negatively to rising inflation, but real estate reacts proportionally, often increasing 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 increase in line with inflation and a borrower has debt that was incurred before the rise in inflation, the increase in inflation can benefit the borrower. The borrower still owes the same dollar amount back, only now they have more money in their paycheck 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 unit of currency to decrease over time, and depending on your circumstances, this 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 tough to get into the property market, agents can have a harder time finding buyers and tenants can struggle to find affordable options. On the contrary, landlords without the burden of increasing loan costs will sit pretty.

Interest rate hikes, combined with pandemic-driven price increases, are currently causing some affordability issues in markets that have recently experienced significant growth. While this cools demand in some of these markets, the continued lack of property inventory helps minimize the extent to which values ​​will fall.

Overall, one of the reasons investors favor real estate is because of their solid ability to withstand the pressures of rising inflation and emerge with values ​​intact, even enhanced.

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