Real Estate Investments and Inflation: Strategies to Protect Your Wealth
In the exciting world of real estate investing, real estate is often touted as a solid defense against inflation. But how does this strategy really work, and what does it mean to “close against inflation”? In this article, you’ll dive into the fascinating world of real estate and discover why it’s a reliable safe haven in inflationary times.
Inflation: Is the sustained increase in prices over a given period, such as rising home values or rental costs.
Common causes of inflation include: excessive currency issuance, supply and demand shocks, and the expectation that prices will continue to rise.
Real estate as a safe haven: Investors use real estate to hedge against inflation by taking advantage of low mortgage rates, passing on cost increases to tenants through higher rents, and benefiting from rising property values over the long term.
Inflation is the sustained increase in the prices of goods and services over a specified period, usually one year. According to the U.S. Bureau of Labor Statistics, in October 2021, the annual change in consumer prices rose 6.2%, more than double the Federal Reserve’s inflation target of 2%.
Another way to understand inflation is as the loss of purchasing power of money due to rising prices. According to the Federal Reserve, the average purchasing power of the dollar has declined by a staggering 96.5% since 1913. In simple terms, what used to cost a dollar over 100 years ago now requires more than $20.
This erosion of the value of money manifests itself in every aspect of daily life: from the cost of filling up a tank of gas to buying a gallon of milk, renting a home or purchasing an investment property.
Common Causes of Inflation
Inflation is not an enigma, but the result of several factors identified by the International Monetary Fund:
1. Easy monetary policy: excessive currency issuance, often referred to as “money printing,” increases the money supply, which reduces the value of each unit of currency. As an example, the $5 trillion stimulus during the pandemic exceeds by more than three times the aid granted during the 2008-2009 financial crisis.
2. Supply Shocks: Natural disasters or trade shutdowns can create shortages of goods and services, resulting in higher prices due to greater demand than supply.
3. Demand Shocks: When interest rates decrease or investors compete for rental properties, there may be an increase in demand, which drives prices up.
4. Expectations of Rising Prices: Expectations that prices will rise often become self-fulfilling. When individuals or businesses anticipate price increases, these are incorporated into wage negotiations and rental price adjustments, further increasing inflation.
How Inflation Impacts Real Estate
Real estate has proven to be a sound investment during inflation due to several key reasons.
One reason is that investors seek assets that generate returns above the rate of inflation. Rental income earned from tenants is used to cover operating expenses, taxes and mortgage payments. The remaining money is converted into investment returns, expressed as a cap rate. Currently, average cap rates for single-family rentals reach 5.8% according to Arbor Research, with some properties projecting even higher rates, exceeding 7%.
Shortage of Properties
Another reason is that there is a limited amount of real estate compared to the currency in the country.
is real estate compared to currency in circulation. As the money supply increases due to the issuance of money, real estate prices tend to rise. Let’s simplify this with an example: imagine a fictitious economy with a million dollars and a hundred houses, with no other goods or services available. If each house were identical, it would be worth $10,000.
Now, suppose the central bank prints an additional $1 million overnight. Now, the economy has two million dollars in total, and each house would be worth $20,000. As the IMF explained, money printing is one of the factors contributing to inflation and rising real estate prices.
Rising Construction Costs
Inflation also affects the cost of building a home due to rising wages and more expensive materials, supplies and land costs. As a result, homebuilders pass these costs on to buyers and real estate investors. This further contributes to rising real estate prices. The National Association of Home Builders (NAHB) recently reported that overall prices for building materials increased more than 19% over the past 12 months and 13% year-to-date. These materials include products such as lumber, gypsum board used to finish walls and ceilings, and ready-mix concrete.
How Investors Use Real Estate as a Hedge Against Inflation
During periods of inflation, prices of virtually everything tend to rise, including housing costs, rents and, in many instances, mortgage interest rates. Investors have developed several strategies to protect their assets and take advantage of inflation:
1. Take Advantage of Low Interest Rates: Mortgage rates are at historically low levels, averaging 3.07% for 30-year fixed mortgages according to Freddie Mac as of October 2021. These low rates allow investors to take advantage of affordable money today, avoiding higher rates in the future.
2. Pass Inflation on to Tenants: Owning a single-family rental property gives investors the opportunity to pass on rising costs to tenants through higher monthly rents. According to Arbor’s latest single-family rental investment trends report, rent growth from vacant to occupied units increased 12.7% year-over-year, compared to the reported inflation rate of 5.4%. Since May 2020, annualized rent growth has averaged 8.1% for single-family homes, compared to historical average rent growth of 3.3%. In other words, recent rental price growth exceeds inflation by 2.7% to 7.3%.
3. Benefit from Rising Asset Values: Throughout history, home prices have risen over time, making real estate a valuable hedge against inflation. According to the Federal Reserve, the median sales price of U.S. homes has risen an impressive 345% since the third quarter of 1990 and nearly 20% since the third quarter of 2020.