How to Think About Real Estate During Inflation
In June of 2024, the US inflation rate rose to 9.1%, the highest it’s been since November 1981, when inflation hit 8.6%. Stuff is getting more expensive every day, and many Americans are hurting. We’re currently in the midst of a period of accelerated inflation, the likes of which we haven’t seen since the early 1980s.
There are several reasons why this is happening, including unprecedented money creation, robust government spending, supply chain snafus, and ongoing issues from the COVID-19 pandemic- among other causes. But what does this mean for real estate?
As a real estate investor, it’s incredibly important that you understand the big questions behind inflation and how investors can survive or even thrive during periods of high inflation.
Inflation
Inflation and Real Estate: Fast Facts
- Inflation is a general increase in the prices of goods and services in an economy.
- Our current high rate of inflation has several causes, including Federal Reserve money creation, government spending, supply chain issues, and energy/oil shocks.
- Real estate is often seen as a hedge against inflation, as property values typically increase along with inflation. This means that your investment in real estate will likely increase in value as inflation goes up.
What is inflation?
Inflation is a concept in economics that refers to the overall increase in the prices of goods and services in an economy. It's often used as a measure of the health of an economy. When inflation is low, it indicates that the economy is performing well and prices are stable. When inflation is high, it can be a sign that the economy is struggling.
What causes inflation?
While inflation has many potential causes, it is often caused by an increase in the total money supply. When the money supply increases, more money is chasing the same number of goods and services. This increase in the amount of money in an economy can lead to inflation as businesses raise prices to try and keep up with the extra money in circulation. Inflation can also be caused by an increase in production costs.
If it costs more for businesses to produce goods and services, they may pass those costs on to consumers through higher prices. Inflation may also be caused by a decrease in the supply of goods and services. When there is less of something available, the prices of those goods and services tend to go up.
How to calculate inflation rate?
Inflation is often calculated using the consumer price index, which measures the prices of a basket of consumer goods and services. The inflation rate is the percentage change in the consumer price index over time.
There are several ways to calculate the consumer price index, but the most common method is the arithmetic mean. This method involves taking the prices of a basket of goods and services and finding the mean. The weights of the different items in the basket are determined by their importance in the consumer's budget.
The inflation rate is usually calculated on a yearly basis, but it can also be calculated on a monthly or even daily basis. The most common way to report inflation is in terms of annual percentage change.
In order to calculate the inflation rate, you need to know the consumer price index for the current year and for the previous year. The formula for calculating the inflation rate is:
Inflation rate = (Current CPI - Previous CPI) / Previous CPI
For example, if the consumer price index in 2019 was 100 and the consumer price index in 2020 was 105, the inflation rate would be 5%.
It's important to note that the inflation rate is not the same as the overall price level. The inflation rate is a measure of the change in prices, not the level of prices.
The rate of inflation is an important economic indicator because it can have a significant impact on economic decision-making. For example, if the inflation rate is high, people may be less likely to invest in businesses or buy homes because they expect prices to continue to rise.
If you're trying to calculate the inflation rate, there are a few things to keep in mind. First, make sure you're using the correct consumer price index. You also want to remember that the inflation rate is the percentage change in the consumer price index, not the overall level of prices.
Why is inflation so high?
Inflation has been a popular topic in the financial press lately, with prices rising and people struggling to make ends meet. But why is inflation so high? Several factors contribute to inflation, but the main one is the simple law of supply and demand. When there is more money chasing after fewer goods, prices go up.
Other factors contributing to inflation include the cost of raw materials and energy, which have been rising in recent years. The War in Ukraine has caused knock-down effects in several markets, like petroleum and grain. Put another way, it's raised the price of energy and food for billions of people across the globe, which manifests as inflation. Additionally, wages have not kept pace with inflation, which means people have less purchasing power.
All of this has been exacerbated by the coronavirus pandemic, which has led to a decrease in global trade and an increase in demand for certain goods and services. This has caused prices to skyrocket, and it doesn't seem like they're going to come down anytime soon.
Energy is a major driver of our current inflationary woes.
What is the current inflation rate?
Inflation rates are expected to continue to rise in the coming months, reaching 9.1 percent in July, according to a new report from the Bureau of Labor Statistics. The July numbers are up from the [8.4 percent rate seen in May](https://www.cbsnews.com/news/inflation-june-cpi-report-hit-new-high-40-years-9-1-percent/#:~:text=Inflation hit a fresh 40,above what economists had expected.) and represent the highest inflation rate since September 2008. The leading cause of this inflation spike is rising prices for goods and services, driven by increased demand and limited supply.
Items like food and gas are heavily affected by this phenomenon, and both have seen prices increase rapidly in recent months. While the inflation rate is expected to moderate in the second half of the year, it is still likely to remain above the Federal Reserve's target of 2 percent.
Rising rates could pressure the central bank to raise interest rates sooner than expected to keep inflation in check. For now, consumers will need to brace for higher prices on everything from groceries to airfare. And, with the economy continuing to recover from the pandemic, there's a good chance that inflation will remain elevated in the months ahead.
As demonstrated by the chart below, we’re in the middle of a heightened recessionary period, the likes of which we haven’t seen since the late 1970s and early 1980s.
Source: St. Louis Federal Reserve
What to invest in during inflation?
In two words**- real estate**. Inflation is often viewed as the enemy of savers and investors. But, inflation can also present opportunities for those who are willing to take advantage of them. For example, during periods of high inflation, commodities tend to do well. This is because as the cost of living goes up, the prices of raw materials increase as well.
When inflation happens, it's important to invest in things that will increase in value. This includes things like gold, silver, and real estate. Gold and silver are precious metals that will always be in demand. Another asset class that can do well during periods of inflation is real estate.
This is because, as rents increase, so do the prices of properties. Additionally, it holds value because it's a limited resource. As early movie pioneer Will Rogers once remarked: "Buy land. They ain't making any more of the stuff."
Real Estate and Inflation
When it comes to inflation, most people think about the prices of goods and services rising. But did you know that inflation can also affect your real estate investments?
In general, inflation is good for real estate. That's because as prices go up, the value of your property also increases. If you own a home, your home is likely to be worth more in 10 years than it is today.
The same applies to other real estate types, such as commercial buildings and land. Land is an excellent investment during periods of inflation because it is a limited resource. Only so much land is available, so as demand for it increases, the price goes up.
Of course, there are some potential downsides to inflation as well. For one thing, it can make it more difficult to afford a home or other property. As prices increase, incomes usually don't keep pace, making it harder to save for a down payment or make monthly mortgage payments.
In addition, inflation can make it challenging to compare prices from one year to the next. For example, let's say you're trying to compare the cost of a new car today to the cost of a new vehicle ten years ago. Today's car is likely to be much more expensive, but it's also likely to have many more features. So it's hard to know how much of the price increase is due to inflation and how much is due to the addition of new features.
What will happen to real estate during inflation?
As an asset class, real estate has consistently outperformed the stock market and other investments for the past two decades. That’s largely because, as an inflation-hedge, real estate has proven to be a much more compelling investment than stocks, bonds, and other traditional assets.
In contrast, stocks and bonds tend to lose value when inflation goes up. That’s because the companies that issue stocks and bonds generally don’t increase their dividends and interest payments to keep pace with inflation. As a result, the real value of these investments goes down over time.
How does real estate protect from inflation?
Real estate is a physical asset not subject to the stock market's volatility. Over time, the value of real estate generally increases as a result of inflation. This tendency makes real estate a good investment for those looking to protect their wealth from the effects of inflation. There are several reasons why real estate offers protection from inflation.
Rental Incomes Tend to Grow With Inflation
Real estate generates income in the form of rent. This steady cash flow can provide a hedge against inflation, as the rent payments will increase along with the cost of living. For example, if the cost of groceries goes up by 10%, the rent on a property will also increase by 10%.
As the cost of living increases, so do the prices of goods and services, including the cost of rent. When inflation is low, rents tend to increase at a slower pace, and when inflation is high, rents go up at a faster clip.
Another reason rental incomes grow with inflation is that wages also tend to increase along with the cost of living. When tenants get paid more, they have more money to spend on rent. And when there is more demand for rental units, landlords can charge higher prices.
Of course, other factors can affect rental prices, such as the economy's state and housing availability. But in general, inflation is one of the main drivers of rising rents.
Landlords and Property Investors Tend to Have Fixed Costs
The costs of maintaining and operating real estate tend to be relatively fixed, which means real estate assets are not as impacted by inflation. For instance, say you have a 30-year fixed-rate mortgage at 3.5% that you got in 2020. Since you have a fixed rate, your mortgage payment is going to remain the same for the next 30-odd years unless you refinance.
Commercial property leases often operate in a similar manner, with leases that can last multiple decades. Additionally, in the case of single, double, and triple net leases, landlords can pass on variable costs- like electricity or maintenance- to tenants, further insulating real estate owners from inflation’s deleterious effects on their bottom line.
Real Estate Tends to Appreciate Over Time
It's no secret that real estate tends to appreciate over time. While there are many factors that contribute to this, one of the most important is simple supply and demand. As the population grows and more people are looking for a place to call home, the demand for housing increases. This, in turn, drives up prices and causes real estate to appreciate.
Inflation is also a key factor in why real estate tends to appreciate at a faster rate than other investments, such as stocks and bonds. This is because, as the cost of living goes up, the value of money goes down. This means that, over time, a dollar will buy less and less. But, since real estate is a physical asset, its value is not affected by inflation in the same way that the value of stocks and bonds is.
Of course, there are other factors that contribute to real estate appreciation, such as population growth, economic growth, and interest rates. But, inflation is one of the most important drivers of real estate values over the long term.