Inflation has been in the news a lot in 2022. What exactly is inflation? Inflation is the rate at which prices increase for goods and services. Groceries, building materials, housing, labor…the cost of nearly everything consumers buy is going up. This means we have less purchasing power. $1 today will not buy as much as it would five years ago. Or even one year ago. In the 2020s inflation is rising fast!
Data from the Bureau of Labor Statistics offers some interesting insight into how the rate of inflation has changed over time. Over the past 30 years, the rate of inflation has been in the perfectly manageable 1-3% range. But, by the end of 2021, the inflation rate was over 5%. And, by the beginning of 2022, the rate was over 6%.
So, we want to explain a few things about today’s inflation rates:
Why rates are rising,
What happens to real estate during inflation,
How interest rates and inflation are connected,
And how real estate investors can use real estate as a hedge against inflation.
Here’s what you need to know about the relationship between real estate and inflation.
Why is the Rate of Inflation Going Up?
Economically speaking, there are a few factors that cause inflation to rise. And we’re seeing all of them today.
Availability of money. At the beginning of the COVID pandemic in 2020, the economy was on the brink of a recession. Non-essential In-person services were heavily restricted, resulting in business closures and job loss. So the government injected cash into the economy through an unprecedented stimulus package. This had the desired effect of avoiding a full-scale recession, but the additional cash in the economy contributed to rising inflation.
Supply shocks. Supply and demand play an important role in inflation rates. We’ve experienced a few shocks on the supply side recently. In addition to the COVID pandemic disrupting supply chains of all consumer goods, we’ve also seen the supply of gasoline diminish because of Russia’s invasion of Ukraine and the subsequent, widespread boycott of Russian gas.
Demand shocks. The pandemic can also be blamed for recent demand shocks. For example, the stay-at-home orders issued in many states resulted in a sudden demand for more electronic devices, which resulted in a global semiconductor shortage.
Expectations of inflation. Continuing inflation is partly a self-fulfilling prophecy. When consumers expect inflation, they behave as if inflation is inevitable, which accelerates the rate of inflation. For example, we’re rushing to buy items in short supply before they’re gone, which drives the prices up higher.
Inflation Effect on Real Estate
Inflation and real estate typically have a direct relationship. As inflation rates rise, so does the value of real estate.
According to data compiled by the Federal Reserve in St. Louis, the median purchase price for American single-family homes in 2022 was at an all-time high of $428,700. Only two years before, the median was just $322,600. From the end of 2020 until the end of 2021, the national median grew by 17.8%. This is the highest year-over-year housing market growth since 1973 when home values jumped by 18.4%. And what else do you think happened in 1973? That’s right; there was a jump in the inflation rate. The BLS data shows that the inflation rate was 8.3% in 1793, compared to just 3.6% the prior year.
Consider how the housing market has been affected by the inflation real estate correlation based on the factors we’ve seen:
Availability of money. In addition to stimulus checks, many office workers were able to retain their jobs, working from home. Many were even able to relocate further from the office where they had greater buying power due to lower home prices.
Supply shocks. Today’s homeowners decide to “age in place” rather than downsize to retirement communities as previous generations did. This means fewer homes available for the new generation of buyers. Couple this with low housing construction since the recession, and we have a low supply.
Demand shocks. The time spent at home during the pandemic prompted people to prioritize their living space. Coupled with low interest rates and rising rents, homebuying has been exceptionally appealing in the early 2020s. This resulted in bidding wars and purchase prices over the asking price.
Expectations of inflation. The housing market is a prime example of expectations leading to greater inflation. When buyers see housing prices rising, those who are able to buy are suddenly in a rush to do so, which drives the home prices higher.
Is Real Estate an Inflation Hedge?
You may have heard that real estate is a “hedge against inflation.” And this is absolutely true.
A hedge is simply a risk mitigation tool. All investments carry some level of risk (even real estate, which is considered a low-risk investment). And savvy investors will mitigate risk by creating a diversified portfolio so that the value of one asset will automatically increase because of the same economic force that causes a different asset to decrease.
Let’s consider an example.
Low-yield investments like savings accounts, CDs, and bonds might not earn much, but investors include them in their portfolios because they are among the safest investments possible. If they earn 3% per year, and the inflation rate is just 1%, you come out ahead! But higher inflation devalues these investments. If inflation is at 5%, you’re effectively losing money with your 3% returns.
But the same rate of inflation that devalues your low-yield investments boosts your real estate investments in multiple ways:
The value of your property will go up. Real estate appreciates more quickly when inflation is on the rise. Just look at how today’s seller’s market compares to the buyer’s market of the Great Recession.
You can command higher rental rates. While it’s true that your ownership costs (like insurance, maintenance, and repairs) will increase due to inflation, you can essentially pass this added expense through to your renters in the form of increasing rents.
Inflation is devaluing your mortgage debt. Every dollar of debt you currently have is worth less today than when you accepted the loan.
Inflation, Real Estate, and Interest Rates
A plan is already in motion to slow the rate of inflation. The Federal Reserve is raising interest rates.
In May of 2022, the Fed announced the biggest interest rate increase in over 20 years. Raising interest curbs inflation by making it more expensive to borrow money. This slows the flow of cash through the economy and brings inflation back to a more sustainable pace.
This directly impacts homebuyers as federal interest rates correlate directly with mortgage rates. A 30-year fixed-rate mortgage in April 2021 could cost you as little as 3.06% per year. By April 2022, the rate was up to 4.98%.
So, it’s not just consumer goods and home values that rise with inflation; it’s mortgage rates as well. Once inflation is under control, mortgage rates will stabilize.
Hedge Against Inflation by Investing with Gatsby Investment
With real estate serving as such a solid hedge against inflation, investors have been taking full advantage of real estate investments. We’re now at the point where some investors wonder if they’ve missed the boat. Inflation has driven home prices and construction costs so high that the upfront investment for a single property is simply too high for many investors.
Syndication is similar to crowdfunding; you can use a low minimum investment to buy a piece of a real estate deal. But, unlike many crowdfunding platforms, Gatsby uses a syndication ownership model, which creates a stable ownership entity for each project with each owner becoming a member of the LLC that owns the underlying real estate. And, with Gatsby, you have a team of experts who know how to find off-market deals, negotiate the best terms, and add value to real estate in ways that allow investors to capitalize on periods of high inflation.
Gatsby Investment specializes in residential properties in Los Angeles County. With a wide range of investment types, you’ll find a project that works with your timeline. And with the LA real estate market forecast looking so bright, it’s not too late to use today’s high inflation rates to your advantage.
