If you’ve been paying attention to current events in any capacity, you’ve probably heard about record high levels of inflation that are affecting the United States (and, to a lesser extent, countries around the world). Most of us experience inflation in a relatively passive way, noticing increased prices for common goods sold at the grocery store and commodities like gasoline.
But on a higher level, inflation has significant economic influence. If you’re an active investor in the real estate space, you should be prepared to adjust your strategy in response to changing inflationary conditions.
How does inflation affect you? And what should you do about it?
What Is Inflation?
First, let’s talk about inflation. Colloquially, we use the general term “inflation” to mean price inflation, which occurs when the value of a currency decreases and the prices of everyday goods increase in response. If you used to pay $10 for a bag of chicken, and the value of a dollar goes down by 10 percent, you can expect the bag of chicken to cost $11 or so to make up the difference.
Economic inflation is a complex phenomenon that can’t be tied to a single variable exclusively. However, inflation tends to set in whenever there is an increase in the money supply. Over the last few years, we’ve seen record low interest rates offered by the Federal Reserve, increasing available capital to lending institutions and creating ridiculously low interest rates for consumers at the bottom of the food chain. We’ve seen increased levels of quantitative easing, with the Fed dumping more money into the stock market and other assets. We’ve also seen the rollout of trillions of dollars in stimulus money to both businesses and individuals.
It’s debatable whether these moves were a beneficial or “correct” decision. But it’s hard to debate that these actions have collectively led to the inflation we’re seeing today.
Because prices increase in an inflationary environment, most consumers intuitively believe that inflation is inherently a bad thing. But while inflation does have some problematic effects, there are also some advantages and opportunities to understand.
Inflation and Debt
One of the most important effects of inflation for real estate investors to understand is that inflation tends to favor people who currently hold debt. This occurs for several reasons.
For starters, the value of the currency is decreasing. If you have $300,000 of debt, and the value of a dollar decreases, the value of your debt is going to correspondingly decrease; it’s almost like having some of your debt paid off for free.
If your debt is tied to a specific asset (as is the case with a mortgage), you benefit in an additional way. The prices of goods and assets tend to increase with inflation, according to the inflation rate. In other words, the price of your house may increase while your debt remains the same. This is one reason why real estate is such an attractive long-term investment option, considering the United States intentionally tries to maintain a steady inflation rate at all times.
This means that you stand to benefit by having more good debt (emphasis on “good”) when inflation is active. That doesn’t mean you should go out and get as much debt as you can right now, but if you’re currently holding debt, and inflation continues along this course, you’ll benefit materially.
Inflation and Asset Prices
Inflationary environments cause price increases, and those price increases extend to the real estate world. Real estate prices don’t increase with the same volatility as gasoline prices, but they will rise in line with overall economic changes. Accordingly, you can expect to pay a higher dollar amount for property in the near future, even if the value remains the same.
Inflation and Rental Prices
Similarly, we can expect a proportional rise in rental prices. In some ways, this practically cancels out the rise in asset prices; you’ll be responsible for paying a higher dollar amount for your property, but you’ll also be able to charge a higher dollar amount in monthly rent.
Inflation and Interest Rates
We also have to consider the effects that inflation may have on interest rates. Generally speaking, the Federal Reserve is responsible for maintaining healthy economic growth. Some of their responsibilities include controlling interest rates to influence the money supply. When the Federal Reserve acknowledges high rates of inflation, they typically respond by increasing interest rates – a form of monetary tightening designed to restrict the money supply in an effort to combat inflation.
We are already seeing the beginnings of this, with interest rates gradually rising over the past year or two – and the Fed has announced plans to increase interest rates further in the near future.
The downstream effect of this is typically higher interest rates for end borrowers. Banks and lending institutions borrow money from the federal government at a higher interest rate, so they must charge higher interest rates to their customers to make up the difference. It’s only a matter of time before mortgage interest rates rise. This could discourage real estate-related borrowing, while simultaneously reducing demand (and therefore reducing prices).
Current vs. Future Inflation
We need to be cautious about discussing inflation as a motivation for making certain real estate decisions, because current inflation isn’t the same as future inflation. Just because we’re experiencing a high rate of inflation now doesn’t mean we’re going to see that same rate for many years to come. If you make all your real estate investing decisions based on present conditions, it’s only a matter of time before your strategy collapses.
Nobody can see into the future, but it behooves you to think about how conditions may change in the near future, rather than conditions as they currently exist.
The Bottom Line
Inflation is a complex economic phenomenon, and one worth understanding if you want to make smarter real estate investing decisions. With advantages for debt holders, higher interest rates, higher asset prices, and higher rental prices, inflation is a mixed bag. If you suspect inflation will increase in the future or remain high for a long period of time, it could be a smart move to buy new properties for your portfolio – but that all depends on your personal goals and individual risk tolerance.
Are you interested in reshaping your real estate strategy? Are you ready to buy a house or rent a property you already own? Green Residential can help! We have the real estate agents, property managers, and other experts you need to make smarter decisions – so contact us today for a free consultation!