Updated: Aug 26
Inflation refers to the rise in prices of goods and services in a certain economy over a particular period, mostly over a year. In the US, the inflation rate for all items reached 4.9% in April 2023. Assuming you spent $100 on groceries each week in April last year, you might have been paying $104.90 for the same amount of groceries now.
It might not seem like a lot of money to worry about. However, when you add all your bills, including internet, gas, phone bills, and other expenses, you end up spending a lot more money annually.
You can also look at inflation as the decrease in the purchasing power of the currency over time. For example, since 1913, the US dollar’s purchasing power has declined by roughly 96.5%. If you had $1 a century ago, it would only be worth about 3.50 cents today.
Since inflation causes a dollar to buy less over time, you now understand why you need to pay more for your milk, gas, and even rent than you did a few years ago.
Some people confuse inflation with appreciation. The two are different. Appreciation in real estate refers to the rate at which a property’s value goes up over time. The increase in value in appreciation isn’t due to inflation. The value appreciates due to the rise in demand.
It’s common to see the value of property increasing at a higher rate than inflation. It can also depreciate as the economy experiences inflation.
What Causes Inflation?
While it’s no secret that everything nowadays is becoming expensive, what actually causes inflation?
Lax monetary policy: This is also known as money printing. It increases the amount of money in circulation, which, in turn, results in the decline of the currency value. For example, the US government provided a $5 trillion stimulus during the pandemic. It unleashed the largest flood of money ever recorded in US inflation history. The amount was three times more than the approved financial aid during the Global Financial Crisis in 2008.
Supply Shocks: Supply shocks happen when there’s a rise in prices due to an increase in demand but a low supply. It happens when there are natural disasters or business lockdowns.
Demand Shocks: Demand shocks include when you find real estate investors engaging in bidding wars to purchase investment properties with the potential to yield rental income.
Expecting prices to rise: According to the IMF, expectations of rising prices eventually become self-fulfilling. When business people expect the prices to rise, they adjust their prices. In such events, you find rent prices increasing or investors negotiating wages.
How Does Inflation Impact Real Estate Investors?
While inflation can look like a negative thing, it’s not entirely so. There are some positives to note. Let’s break down this section into what inflation means for homeowners, investors, and prospective investors. We’ll look at both positives and negatives.
Inflation for Homeowners
The positives of inflation are mainly enjoyed by homeowners. The most obvious perk is that the value of their homes appreciates with the inflation rate. It can be difficult to get a mortgage during inflation. Due to the high mortgage costs, many people continue to rent, hence driving up the demand for housing.
With high housing demand yet low supply, homeowners can demand higher prices. It’s common to see homeowners receive even higher offers than their asking prices. As you can tell, it makes inflationary periods an excellent time to sell but a hard time to buy.
Inflation for Investors
Investors are another group who tend to experience some positives out of an inflationary market. Say you seek financing to invest in property as a leveraged asset with rates as low as they’re now. You’ll find yourself paying back the same rate while your property’s value rises.
In the current inflation, the financing rates aren’t rising at the same rate as the inflation. It means that your return on investment can soar.
Inflation for Prospective Investors
Prospective investors tend to bear the brunt of an inflationary market. The circumstances are different from those for homeowners and existing investors. Inflationary times lead to high costs of borrowing. Since banks and lenders don’t want to lose their money, they offer fewer loans at high interest rates to reduce their risk.
Inflationary times also lead to a high cost of building. Due to the high cost of borrowing and building materials, new constructions during inflationary periods can be a difficult investment.
While you may want to invest in short-term rentals during an inflationary period, remember that during such times many people tend to cut their travel budgets. Since the vacation rental business is driven by tourism, it may not fare well in such times.
How Does Inflation Impact the Real Estate Prices?
In the past decade, the typical price of an average single-family home in the US has risen by over 90%. According to real estate experts, we can expect home prices to continue rising by 13.6% in the next year.
What causes the increase in home prices during inflation periods?
Demand in Income Generating Assets
One of the major reasons why home prices increase during inflation times is because real estate investors search for assets that will generate rental income above the current inflation rate.
Rental income is the money collected from the tenants and used to settle property expenses, such as property taxes and mortgages. Any money that remains after settling the expenses is the return on investment. We express the rate of return as the capitalization rate (cap rate).
During inflationary periods, investors will look for properties that offer a higher cap rate than other investment options, such as Treasury bonds or high-yield savings accounts.
Limited Real Estate Inventory
Real estate prices during inflationary periods also go up because of the limited amount of real estate compared to fiat currency. You’ll find governments printing more money during such periods to increase the money supply. It causes real estate prices to rise.
For instance, let’s assume that a country has $1 million in circulation and 100 homes are on sale. We’re assuming that there are no other goods or services on sale and that all homes on sale are identical. As such, each property would be worth $10,000.
Now, if the government prints an additional $1 million, there’s a total of $2 million in circulation. It means the homes would now cost $20,000. As you can see, the printing of money is one of the factors that cause the rise in home prices and lead to inflation.
Increase in Home Construction Costs
Inflation causes all prices to increase, including land, wages, building materials, and supplies. As a result, home builders pass the cost of construction to home buyers and investors. It reflects in the current real estate market.
In the past 12 months, building material prices have risen by over 19%. Home construction materials include lumber, ready-mix concrete, and gypsum boards used for finishing ceilings and walls.
What Should Real Estate Investors Do During Inflation Periods?
With all these factors in mind, the most important factor prospective investors must consider during inflationary periods is timing. Ask yourself one question; How long do you intend to own the prospective investment property?
If you want to keep it in the long term, you can expect to enjoy the same benefits as existing owners, such as property value appreciation. If you’re looking to invest in a shorter period, likely through a fix and flip strategy, we advise you to proceed with a lot of caution.
One major danger of investing in the short term during inflation is that you risk getting caught in the real estate bubble. Closing costs during such periods may rise up to 6% of the home selling price. As a new investor, if you don’t have enough equity to settle such costs, then you may lose a lot of money should the bubble burst.