A strong economy can tolerate inflation because wages increase to match the cost of goods, but a weak economy does not tolerate inflation well. When income remains stagnant, yet cost increases, most people end up waiting to make that next big purchase in the hope that prices will go down. Prices subsequently drop because demand goes down.
This simple explanation of inflation does not clarify the answer to the question of why real estate prices are not suffering from inflation. According to Joseph Pingaro, it’s because the correlation between inflation and real estate prices is complicated. There are lots of moving parts and not everyone agrees on their effect. This makes it a challenge to predict how inflation affects real estate prices, but here, we will examine the interplay between inflation and housing costs.
There are two different kinds of inflation and they both affect real estate prices. Cost-push inflation is when the price of goods goes up, and that cost gets “pushed” onto the consumer. Home construction and improvement prices are affected by this type of inflation. Think of the vast amount of material that goes into building a home, from concrete for the foundation, to windows, siding, drywall, flooring, plumbing, and wiring. Inflation can drive up the prices of these materials, in turn driving up the price of the home.
Demand-pull inflation occurs when demand outpaces supply. If there are fifteen houses on the market and twenty people looking to buy, the price of homes will adjust to be congruent with demand.
The recent housing shortage has been driving up the price of real estate because there is not enough of it to go around. New construction permits are at a current high, yet it still does not seem to be enough to keep up with demand.
Interest rates further complicate the effect of inflation on real estate prices. Usually, when inflation is high, then mortgages become more expensive with rising interest rates. Right now, interest rates remain at record lows in an effort by the federal government to stimulate the economy.
Low interest rates are helping real estate remain remarkably affordable despite rising demand and the higher cost of materials. Because it is relatively inexpensive to borrow money, real estate prices can keep climbing without negatively affecting demand.
Inflation means that money is worth less over time. For example, something that cost $1.00 in 1980 would cost $3.28 today. When you purchase stocks, the value of your dollar remains subject to the rate of inflation. If you began investing for retirement in 1990 counting on a million dollars to get you through retirement, you may be in for a shock when you find out how depreciated the value of a million dollars has become.
If you purchased a home for $100,000 in 1990, it would take the buying power of almost $200,000 today to purchase the same home. So your investment is protected.
The rate of inflation does not take into account the appreciation in value of your real estate. If we look at the numbers, we can see that real estate prices have gone up consistently throughout history, with only a few hiccups. Even with the hiccups, prices always recover eventually. According to Forbes, values have historically increased by 3-5% annually.
One benefit of inflation is that the value of debt depreciates too. If you took out a mortgage with a payment of $1,000 a month in 1990, then you would still be paying $1,000 a month now; but it would take nearly $2,000 to have the same buying power today.
Owning rental investment properties takes protection from inflation to the next level. Ideally, you can increase rent annually. If you profit from your rental income in the first year by $100 a month after all of your expenses are paid, and you raise your rent by $10 a year, you will double your profits in ten years.
Investing in real estate is a smart way to generate income either through actively buying or selling properties or through passive methods like owning rental properties. There are tax breaks that allow you to keep more of your profits, too, but one of the biggest benefits of owning real estate is the ability to protect your money and hedge against inflation.
Currently, prices are climbing, and will likely continue in an upward direction into the future, but historically low interest rates make buying real estate more affordable than ever. Buying now means you used the power of your dollar to maximize the power of your money in the future. When you look back, you will be glad you did.