Inflation plays an important role in the economy. With unprecedented levels of government stimulus over the last few months, fears of inflation are surfacing after years of stability. What does this mean for your real estate career? What does it mean for you?
Inflation might not be the sexiest topic, but it is an important concept for real estate investors to understand. Real estate is generally considered one of the best ways to hedge against inflation risk, and understanding inflation will help you manage potential concerns and better understand one of the fundamental forces in our economy.
What is inflation?
In its simplest form, inflation basically makes your money worth less. This is precisely why everyone hates and fears it. Inflation occurs in an economy when the cost of goods and services increases.
A good example is gas prices. When the price of a gallon of gas goes from $2 to $3, you’re getting the same amount of gas, but you have to pay more for it. When gas is $2 per gallon, a dollar buys you a half-gallon of gas. When the price rises to $3/gallon, a dollar only buys you a third of a gallon of gas. The purchasing power of your dollar has declined. This is inflation in a microcosm.
To measure inflation holistically, the government tracks goods and services over time. The most prevalent one is the Consumer Price Index, and right now it’s going up.
The government uses this type of index to set a target rate for inflation. Yes, the government actually wants some inflation. Lots of inflation is bad, but a little bit of inflation is needed to fuel economic growth. Why? Because it incentivizes people to spend their money before it becomes less valuable. And more spending generally equals more economic growth.
Typically, the Federal Reserve sets the target inflation rate at around 2%.
Why is inflation a concern right now?
Inflation hasn’t really been a problem in the United States since the ’80s. As you can see from the chart below, inflation has sat between 0-4% for most of the last 25 years.
This is important to note because there were big inflation fears surrounding the 2009 stimulus package that never actually materialized.
Inflation has been in the news again recently for the same reason: An unprecedented level of government stimulus has been injected into the economy, and many fear this could generate excessive inflation.
The basic thinking is that so much money injected into the economy at once will overheat the economy and give businesses the power to raise prices, causing inflation. There’s just so much money flowing through the economy, and that gives businesses pricing power.
Others point to the 2009 stimulus and the last decade of low inflation as a counterpoint. The idea is that the government is not just injecting money into the economy for fun. It’s doing so to help recover from a crisis—to restore consumer demand to where it “should” be—and therefore the money won’t have the inflationary effect that many fear. Instead, it will reset the economy to where it was pre-COVID-19.
Both perspectives are valid, and the long-term impact of this stimulus on inflation won’t be known for years. However, the Bureau of Labor Statistics did release numbers for March 2021, showing that inflation rose at the highest monthly rate in nearly nine years.
This increase is driven predominantly by energy prices, which are notoriously volatile, and doesn’t really change the forecast for inflation for 2021 all that much. Personally, I’d read more into it if the increase were driven by anything but gas prices. Either way, this has caused the annual inflation forecast to grow modestly from 1.7% in February to 2.6% in March.
Nothing earth-shattering has happened at this point, but it seems likely that the U.S. will exceed the 2% target in 2021. That’s still relatively modest inflation in a historical context, and the government sees that as a worthwhile tradeoff to stimulate the economy out of the COVID-19-induced recession. If the growth rate continues to rise, though, it could have some impacts on other aspects of the economy.
What happens when inflation rises?
When inflation rises in a way that actually makes people fearful, it can cause a chain reaction in the economy that has broad-reaching implications. And really, this all has to do with investors, so welcome to the inflation game, real estate investors.
As we’ve discussed, inflation reduces the value of money over time, which is desirable for exactly no one. To counter this effect, investors of all types look for ways to increase their returns.
If inflation decreases the value of your money by 2% per year, you want to be making more than 2% returns on your investments to at least break even, right?
This effect is very pronounced in the bond markets. Bonds sound exceptionally boring, but it’s honestly crazy how much the economy is centered around bonds. It goes a little something like this.
- Right now, the U.S. government is offering bonds, specifically the 10-year Treasury note (generally considered the safest of all investments), with yields that are about 1.6% as of this writing.
- The government needs investors to buy these notes to pay for stimulus spending and all of the other things the government spends money on. When an investor buys a bond, that investor is essentially lending the government money.
- When inflation rises, the 1.6% return no longer sounds so good to investors. They want a better return to offset the risk of inflation. In return, the government has to offer higher yields on treasury notes, in order to attract investment.
With me so far?
- When bond yields rise, it can (keyword “can,” not “will”) create a more competitive atmosphere for investment dollars.
- If government bonds (again, the safest investment in the world), are offering 2%. then parking your money in a savings account paying 1% no longer sounds so good, right? Why not take the 2% from the government instead? Or maybe you’ll take a little money out of the riskier stock market and put it in bonds to diversify.
- As it relates to real estate, maybe a bank no longer wants to lend you money for a mortgage at 3%, because that may be seen as a lot riskier than a 2% loan to the government (buying a bond). So, banks might instead ask you for 3.5% or 4% on your mortgage to offset the risk of lending to you instead of the government. This is precisely why bond yields have such a big impact on mortgage rates.
Rising bond yields (which can be caused by inflation fears) can increase mortgage rates, which can then cool off the housing market and potentially cool off the stock market (due to people taking their money out of the market and putting it into bonds).
It’s still too early to know the impacts of the stimulus, and inflation is still low in a historic context. But rising inflation matters, as does its connection to the rest of the economy.
As of this writing, bond yields are actually down since the inflation news. So all of this is hypothetical. But inflation still impacts the returns of all types of investors, and it just so happens that real estate investing is an excellent way to hedge against inflation.
Real estate investing & inflation
Real estate is commonly accepted as one of the best hedges against inflation an investor can find. There are two reasons why: asset values, and leverage.
First, owning assets, like a house, is a good hedge. We now know that inflation comes when prices rise. When the price of consumer goods rises, other things tend to as well—things like rent and home prices.
Therefore, in an inflationary environment, owning an asset like a house that increases in price is preferable to holding cash. If you hold cash in an inflationary environment, your money decreases in value each year. With real estate, generally speaking, your property value and rent rise at similar rates (or higher) than inflation, and you at least stay even.
The second benefit is leverage (using a mortgage to buy a property). That’s a whole separate topic, but for now, let’s just look at the impact of holding a loan in an inflationary environment.
For the purposes of this example, let’s assume the following.
- You bought a property for $150,000 and put 20% down.
- The principle and interest on your loan come to $523 per month.
- The property generates $1,000 per month in income in 2021.
- Inflation rises 2% each year, on average, for the next 30 years.
- There is no appreciation in rent or home price other than inflation.
After 30 years of 2% inflation, your rent will be $1,811. That sounds like a lot of rent growth but remember that will have the same purchasing power that $1,000 does today. Because other prices have gone up over 30 years, you would be able to buy the exact same amount of stuff for $1,811 in 2051 as you could buy for $1,000 in 2021.
Put another way, any items on the McDonald’s dollar menu in 2021 will be on the $1.81 menu in 2051.
So, your rent can rise to offset the impacts of inflation, but your mortgage rate is fixed and cannot be adjusted for inflation. While your loan payment in 2051 ($523) is the same as it was in 2021 in numerical dollars, the value of that $523 is far less. How much less? With 2% inflation for 30 years, your payments to the bank will be worth only $285.29 in 2021 dollars.
A simple chart should make this easier to understand.
At the top, we have two lines. The orange line represents rent growing with 2% inflation annually. The yellow line shows what the value of that rent is in 2021 dollars. Remember inflation makes money less valuable, so while rent is going up 2% per year (orange), your buying power stays the same, hence the flat yellow line.
The opposite thing happens with your mortgage payments. The amount you pay each month stays the same (dark blue line), but the amount that payment actually costs you in 2021 dollars declines (light blue line) because inflation is lowering the value of that money over time. The gap between the yellow line and the light blue is your profit: rent in 2021 dollars minus mortgage payment in 2021 dollars. The gap gets bigger over time, which we like.
Beautiful, right? You’re allowed to raise rent to keep pace with inflation. The bank cannot. Your profit grows. Keep in mind this is an oversimplified example and doesn’t account for cost increases for goods, services, expenses, etc.
So, while no one welcomes inflation, you can see that owning real estate—particularly cash-flowing real estate—is a great way to hedge against it.
While personally I am not particularly worried about run-away inflation, I do think the current environment makes for a good investing opportunity. Yes, prices are high, but mortgage rates are super low. And with even the potential of inflation on the horizon, it might be wise to invest in a rental property to hedge that risk.