Is Inflation a Good Thing for Real Estate Investors?

Is inflation a fearsome thing, something to be avoided at all costs? Judging from recent news coverage, it appears that inflation is an economic villain, a threat to financial security, and a danger to the nation’s well-being.

Or maybe not. Perhaps inflation within reason is a benefit for real estate investors and property owners in general.

“Buying a home wouldn’t make much sense if house prices were likely to decline further; no one wants to catch a falling knife,” said Mark Zandi, writing in The Washington Post in 2013.

Zandi, chief economist with Moody’s Analytics, added that “no one should expect the value of their house to appreciate quickly — counting on your home to be a significant part of your retirement saving isn’t a winning strategy — but it is reasonable to expect that prices generally will rise with at least the rate of inflation for some time to come.”

Inflation and wealth

Inflation is generally seen as a situation where currency buys less and less and prices rise. Wealth is commonly defined as having more and more cash, but because of inflation more money is not necessarily evidence of additional wealth. For instance, according to the Cato Institute, in June 1946 Hungary had an inflation rate of 195% – per day. Prices doubled every 15.6 hours.

The real definition of wealth is the ability to buy more. If the annual inflation rate is 2% and your dollars buy 2% more than last year, then you’ve broken even, your buying power is unchanged. However, if the inflation rate is 2% and your income or the value of an asset increases 5% then you’re doing very well, your buying power has increased.

All of which brings us back to real estate. Real estate does very well relative to inflation in some years, and in other years not so much. Lately, however, real estate has been on a tear.

To see what’s happened, look at recent annual inflation rates and average existing home prices.

There are no guarantees that real estate values will go up or that they will increase as fast or faster than the rate of inflation. While there’s always risk in the marketplace, the Fed figures suggest that — in recent years at least — the purchase of real estate five or ten years ago for many if not most owners has meant a solid increase in net worth as property values have outpaced the inflation rate.

Will we see the similar results going forward? As they say on Wall Street, past performance does not guarantee future results.

2021 inflation

For 2021 it looks as though we will continue to see a huge gap between the inflation rate and existing home values. As of October, according to the National Association of Realtors, the typical home sold for $353,900. That’s up 13.1% year-over-year (YOY). Meanwhile, the Bureau of Labor Statistics says the inflation rate during the same period rose by 6.2%.

That 6.2% is the biggest jump we’ve seen since the early 1980s and raises a question: Are today’s high inflation rates temporary or an ongoing threat to the economy?

“Inflation is elevated,” said the Fed in early November, “largely reflecting factors that are expected to be transitory. Supply and demand imbalances related to the pandemic and the reopening of the economy have contributed to sizable price increases in some sectors. Overall financial conditions remain accommodative.”

The Fed has now moved to maintain the federal funds rate (the rate banks pay for overnight borrowing) but reducing securities purchases. If the Fed action is correct, the effect should be a gradual increase in the interest levels charged by banks.

Alternatively, if the inflation levels now being seen are truly transitory we could see less inflation six months from now. For instance, if computer chips become more available we could see expanded auto production. Price pressure for new and used vehicles would fall and this would eliminate one of the biggest factors underlying today’s inflation levels. Prices are also likely to fall if we can speed-up the unloading of container ships off the west coast.

Expect inflation

Public policy in the US favors a touch of inflation, not too much but not too little.

The Fed explains that “inflation of 2% over the longer run, as measured by the annual change in the price index for personal consumption expenditures, is most consistent with the Federal Reserve’s mandate for maximum employment and price stability. When households and businesses can reasonably expect inflation to remain low and stable, they are able to make sound decisions regarding saving, borrowing, and investment, which contributes to a well-functioning economy.”

“What the Fed really means is that a little inflation puts some spunk into the economy,” said Rick Sharga, Executive Vice President with RealtyTrac. “Maybe now is the time to buy if you know that prices will be higher next year. Without inflation, you can delay buying plans because tomorrow’s prices will not be higher, there’s no cost penalty for waiting. Trying to move inflation up or down is a mechanism the Fed uses to spur buying and with it employment and business opportunities.”

Real estate & inflation

Inflation has its pros and cons, and that’s certainly true in terms of real estate. You’ve locked in the acquisition price if you’re a property owner so with inflation it takes more cash to buy your property, the apparent value has gone up. However, the operating costs for such things as utilities, repairs, and taxes are also likely to have risen. Rents should also increase, good news for real estate investors though in rent-control areas it may not be possible to fully re-capture inflation.

Where property owners can do well is with the combination of fixed-rate financing and long-term ownership. The number of dollars needed for monthly principal and interest costs remains unchanged for the life of the loan. The lender is paid over time with cash that with inflation buys less and less. In effect, mortgage payments become cheaper.

If it happens that mortgage rates fall it can often be advantageous for long-term owners to refinance. Ownership costs generally fall with new financing and that’s a good thing in an environment where inflation lurks.