Whether you’re watching the daily news, listening to the radio, or eavesdropping in your local coffee shop, you’ll likely hear conversations about inflation and the state of our economy. Although I’m no economist, I’ve been in the game long enough to know how the ebbs and flows of our economy affect real estate investments. But before we get into that, let’s nail down what we mean when we’re discussing inflation. Inflation is the average increase of the costs of goods and services in an economy over a specific period, generally a year. Essentially, it’s a decrease in the purchasing power of a dollar over time and is partly to blame for the increase in the cost of your daily latte over the past five years.
When it comes to real estate, inflation has multi-faceted effects. Fortunately, in comparison to other investments like stocks, real estate typically performs well in an inflationary economy —but it doesn’t come without risk. While navigating the unchartered waters of high inflation may feel daunting, I’m going to share a bit of industry knowledge to help you steer your real estate investments through our post-pandemic economy.
1) Increased Property Values: During the pandemic, mortgage rates dropped substantially and remained low into 2021. This allowed more homebuyers to enter the market, which increased demand for new developments and overall competition in the market. But, as the global marketplace rebounded from the pandemic, things started to shift. By early 2022, the compounded pressure of supply chain issues and inflation pushed the cost of supplies (and subsequently new developments) to new heights. As a result, we started to see fewer new builds and inventory shortages in some markets. If you’re familiar with economics, then you know that the cost of a good is directly linked to supply and demand. So, with fewer properties on the market (supply), the demand for existing ones will increase and push property values higher, which is great news for those with existing investment properties.
2) The Rental Market will Heat Up: In response to higher inflation rates, The Federal Reserve is forecast to raise short-term interest rates into 2023. As a real estate investor, this means you’ll have a more challenging time securing a loan/mortgage and will be faced with higher interest rates once you do. While this may seem unfair to those looking for a loan, there are a few solid reasons that interest rates increase alongside inflation. The first is self-preservation. In an inflationary economy the cost of nearly everything rises, putting added financial pressure on investors/homebuyers looking for loans and increasing the likelihood of them defaulting on their loans. So, banks become stricter on the loans they approve and require higher interest payments to reduce their risks. Higher interest rates also work to curb inflation by reducing the number of loans and the subsequent spending of those loans, which slows the overall economy.
Although this may all look terrible for those trying to enter the market, it presents a unique opportunity for investors holding rental properties. With higher mortgage rates preventing homebuyers from entering the market, the competition for rentals will heat up and push rental rates higher. Not only that, but as an investor, you can (and should) increase your tenant’s rent in line with inflation (rental agreement permitting). Otherwise, you’ll minimize your return on investment as the purchasing power of your dollar decreases with inflation.
3) Devaluation of Long-Term Debt: Interestingly, inflation is actually good for long-term debt, particularly for those on fixed mortgages. This is because inflation causes the value of money to decline over time. Essentially what that means is that the money you have now is worth more than the (same amount of) money in the future. So, if you owe money (on a loan or mortgage) now, you’re able to pay the bank back with money that is worth less than when you borrowed it. Here’s a simple example to illustrate what I mean by that. Let’s say you bought a property a couple of years ago for $200,000 with a $40,000 down payment. We’ll assume you have a standard 25-year mortgage at a fixed interest rate of 2% for the remaining $160,000. Now, let’s say that every year you hold the property, inflation increases by 3%. On a fixed mortgage, you’ll continue to make the same monthly payments to pay off your debt, but those payments will be worth less as inflation decreases the value of each dollar. Basically, this means that every time inflation increases, the relative cost of your debt decreases (because it’s worth less) — and that’s always good news for investors.
Although I fully recognize the unique challenges of our post-pandemic economy, I strongly believe that there are still gains to be had, especially for those who choose to invest under the guidance of a team of seasoned professionals. At Blue Ridge we’ll help you invest your money wisely, so that your wealth continues to grow through all the ebbs and flows that this post-pandemic economy has to offer.
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