Due to its seemingly volatile nature, inflation acts as a hot topic among investors, since it tends to raise questions such as, “Will my business suffer or benefit from it?”. However, the answer to that question is quite simple since different classes of assets tend to react differently to inflation. This is one of the reasons why, unknown factors – such as the pandemic during the last two to three years – tend to blindside the investors by creating unexpectedness. Real estate is one of the several businesses that act as a severely resistant inflation hedge. Throughout history, it has been observed that Real Estate investments have the ability to perform well in a rising rate environment, due to their ability to generate net income during these expansionary periods.
What is Inflation?
Inflation is the decrease in the purchasing value of the currency, which results in an increase in the prices of goods. This means that each unit of currency will be able to afford a lesser amount of goods or services. If you’re a relatively new investor and don’t have an exact idea of what inflation is, then worry not because an extensive understanding of the concept is not important, however, the way you react to it is.
The Pattern followed by Inflation with Real Estate
Throughout history, the market of real estate has not been negatively affected since a rising rate environment acts as a thriving environment for it. The overall net income gathered by real estate is a significantly larger amount as compared to any other type of asset. This is because an expansionary period does not negatively affect the cost of the property; it reacts in the opposite way since its prices will increase whereas the debt associated tends to decrease.
Effect of Inflation on Real Estate
As discussed above, multiple benefits arise in the favor of real estate during periods of high inflation. Usually, owners observe an appreciation in the prices of properties since the value tends to keep pace with inflation.
Development projects, however, slow down. The increasing cost of the raw materials and services required – just like every other resource – witnesses an increase in price making construction seemingly unfavorable during this time. This in turn leads to a further increase in prices.
Added to that, with the rapidly increasing prices, the construction of houses is significantly slowed down due. This results from the sudden preference for renting, instead of constructing a house due to the increased costs. Even though renting is a lot more affordable during a time like this, rents themselves are also significantly increased by landlords, generating higher revenues.
The Negative effect on Construction
The cost for both, the raw materials and the services increases which can sometimes severely hinder and shut down the construction of new buildings. This can put developers and investors in a scenario where they are a lot more susceptible to cost overruns.
This is why if you are constructing a house today, you need to consider the price changes caused by inflation within the next one or two years.
Is Inflation a Real Estate Hedge?
To recap, real estate is a relatively volatile global market, however stable and steady income streams can be established through it. This is the reason why it is consistently favored by advisors and investors since it can sustain and escape any inflationary pressures unscathed, all while preserving and building value.
More specifically, under such an environment, higher rents and higher assets are produced, which makes it an incredible hedge against inflation. This is due to the general phenomenon discussed above:
- Rents rise with inflation
- The value of the property increases with inflation
- The debt on your asset is devalued as the value of that debt decreases with inflation
Investors, however, should handle such periods effectively considering the cost of borrowing increases resulting in downward pressure on your cash flows as well as your real estate if you wish to liquidate. All of this makes the new real estate development a lot more costly.
All in all, an inflationary period has significantly more positives than negatives on the market of real estate. Investors can utilize those positives through their quick thinking and making several smart acquisitions.
