(Vecteezy)
Ladies and gentlemen, we're delving into the relationship between inflation and real estate prices. Inflation, a lurking economic force, can sway the real estate market. But how? Grab a seat, and let's unravel this complex web together.
Understanding the Dynamics of Inflation
What Happens to Real Estate Prices During Inflation?
First off, let's get on the same page about inflation. Inflation is like a slow leak in your financial tire. It's the gradual rise in the prices of goods and services over time, eroding the purchasing power of your hard-earned dollars. When inflation rears its head, you'll notice that your money doesn't stretch as far as it used to. One way to think about inflation is that goods and services are getting more expensive (relative to money). Another way of thinking about it is money losing its relative value to goods and services over time. Either way you look at it, assets like homes tend to gain in value over time, and one reason this happens is inflation. Homes are a store of value over time, and as the purchasing power of your dollars gets eroded by time and inflation, the cost to purchase a home goes up. However, another way to look at it is that inflation makes your home more valuable over time.
Causes Of Inflation
Inflation has no single cause; it results from complex interactions among various economic factors. Here are some key drivers of inflation:
1. Lax Monetary Policy:
Inflation can be stoked when central banks implement a loose monetary policy. In this scenario, central banks increase the money supply by injecting more currency into the economy, often by purchasing government bonds and printing cash or reducing interest rates so borrowing becomes cheaper. This cash surplus can increase overall demand for goods and services, effectively bidding up prices.
Example: Imagine a scenario where a central bank, facing economic challenges, decides to lower interest rates and increase the money supply. This stimulates borrowing and spending as consumers and businesses find it cheaper to access credit. Prices can follow suit as demand for goods and services rises due to increased spending. This happened during the recent pandemic, as governments struggled to rekindle economies after a massive shutdown.
2. Supply Shocks:
Picture this – a sudden and unexpected disruption in the supply chain due to a natural disaster, geopolitical event, or other significant occurrences. Supply shocks can drastically reduce the availability of certain goods, causing their prices to surge. This is a classic example of the fundamental principle of supply and demand in action, where a limited supply meets strong demand, resulting in higher prices.
Example: Consider a severe drought that affects a central agricultural region. This drought can lead to reduced crop yields and increased production costs. As a result, the prices of farm products like wheat, corn, and soybeans can rise substantially, impacting a wide range of consumer goods, from bread to animal feed. We have also faced a supply shock in recent history, as a global pandemic lockdown slowed logistics and supply of international goods. That meant that global product supply couldn't keep up with demand, and the prices for goods in short supply went up. Remember the scramble for limited toilet paper? How about the spurr of shut-in baking hobbyists trying to buy up a limited supply of flour?
3. Demand Shocks
Conversely, demand shocks occur when consumer demand for goods and services unexpectedly surges. Various factors, such as government stimulus packages, significant shifts in consumer behavior, or other unforeseen events, can trigger this demand surge. When demand outpaces supply, prices can experience upward pressure.
Example: During an economic recovery, a government implements a substantial stimulus program that puts money in the hands of consumers. As people receive these funds, they may increase their spending on various goods and services, creating higher demand. Manufacturers and retailers may struggle to keep up with this sudden surge, leading to price increases as they attempt to balance supply and demand. When the Bank of Canada lowered interest rates to below 1%, they didn't expect a sudden sharp rebound in home buyer demand. This led to a frenzy of home buyer madness where many new homes easily sold +$100k over asking.
Understanding these causes of inflation provides a deeper insight into the intricate web of economic forces at play. Inflation isn't a simple or one-dimensional phenomenon; it's the outcome of dynamic interactions between monetary policies, supply chains, consumer behaviors, and many other factors.
The Ripple Effect: How Inflation Impacts Real Estate
Effects of Inflation on Real Estate
Now that we've got a handle on inflation let's talk business – how does it affect our beloved real estate market? Notably, the above-inflation shocks have become very common in recent years. We’ve had a very lax monetary policy for the last two decades, with low interest rates feeding a booming economy. More recently, we’ve also had a massive supply shock with supply chain logistics disrupted by the global pandemic, leading to shortages in goods and rising prices. Additionally, we’ve had a big demand shock from central banks printing money and lowering interest rates to help global markets bounce back from the pandemic. These factors have led to the rampant inflation that governments and central banks have been contending with until recently. So, how does that relate to real estate?
1. Mortgage Rates
Mortgage rates can impact real estate prices in two ways. First, during the pandemic, there was a huge drop in interest rates intended to stimulate the economy. This led to lower mortgage rates, allowing more people to borrow and buy more homes. With increased demand outstripping housing supply, home prices had nowhere to go but up!
However, the rise in inflationary pressures has forced central banks to take action to avoid entrenched inflation and hyperinflation. One of the most noticeable responses to inflation is the rise in interest rates. When central banks increase interest rates to combat rising inflation, borrowing becomes pricier. That includes mortgage rates. Higher interest rates translate to higher monthly payments for homeowners, potentially impacting the affordability of real estate. In this case, home prices tend to decrease as demand declines.
Example: Suppose you're looking to buy a home with a $600,000 mortgage. With a 3% interest rate, your monthly payment would be approximately $2,840. However, if interest rates rise to 4%, that monthly payment jumps to about $3,320. To maintain the original monthly mortgage rate, buyers must buy a smaller home or wait for interest rates to go back down.
2. Higher Asset Prices
Inflation has a knack for driving up the prices of various assets, and real estate is no exception. As the value of money declines, people often seek refuge in assets that will retain or increase in value. Real estate, a tangible asset with a history of appreciation, becomes an attractive option. This is effectively what has happened to so many homes in the real estate market. Although prices have come down since the rise in interest rates, home values are still remarkably higher than a few years ago. Unless we see a meteoric rise in housing inventory, prices will likely continue to press upward in the long term as inflation causes everything to become more expensive.
Example: A property valued at $400,000 a few years ago might now be worth $500,000 due to inflationary pressures.
3. Inflation Eats Historical Debt
Here's an exciting twist – inflation can effectively reduce the actual value of debt. If you have a mortgage, those fixed payments you agreed to pay years ago might suddenly feel lighter in today's dollars. It's like getting a discount on your historical obligations. Although the actual cost of your debt remains the same, inflation tends to cause everything to go up, including real wages. So, if your current wage has risen compared to a few years ago, but your monthly mortgage payments are the same, then the effective cost for debt servicing has been eroded over time.
Example: You secured a 5-year fixed-rate mortgage for $600,000 three years ago. As inflation erodes the value of money, that $2,840 monthly payment feels less burdensome in today's dollars than it did a few years ago since you're making more money now. Although your monthly mortgage stays the same, your hourly wage has risen from $25 to $30 per hour, leaving you feeling a little richer than before.
4. Increase In Construction Costs
Remember those supply shocks we mentioned earlier? They can hit the construction industry like a sledgehammer. When building materials become scarcer and pricier, the cost of constructing new homes or buildings increases. This, in turn, can drive up the prices of existing properties. This happens in two ways. First, the more obvious way is that the cost of building a home increases. Naturally, the sticker price must go up to match. Second, as interest rates rise, developers' costs can become prohibitive for certain projects. What happens then? Fewer housing developments go online, and the development of housing inventory falls. When there is less housing supply relative to current demand, what happens then? You guessed it, prices increase.
Example: Due to supply chain disruptions, the cost of building a new house has surged by 20%, causing the prices of existing homes in the same neighborhood to rise by a similar margin.
Why Real Estate Flourishes in the Face of Inflation
Why Do Real Estate Prices Increase During Inflation?
Now, here's the million-dollar question – why does real estate seem to thrive amid the turbulence of inflation?
1. Income Generating Asset
Real estate is a unique creature. It's not just a place to live; it's an income-generating asset. During inflation, when the value of money is slipping away, having an investment that generates rental income can be a financial lifesaver. Rental income often rises with inflation, providing a consistent cash flow.
Example: Your rental property, which generated $1,500 in monthly income a few years ago, now commands $1,800 due to increased demand driven by rising living costs.
2. Limited Amount Of Real Estate
Consumer demand is vast, but available land is finite. We can't just conjure more of it out of thin air, and that scarcity can drive up property values. Prices rise as more people compete for the available land and properties.
Example: In a city with limited land for development, increased demand for housing due to population growth drives up property values in desirable neighborhoods.
3. Increase In Construction Costs Of Houses
Remember those pesky supply shocks? When construction costs skyrocket due to material shortages, it becomes more expensive to build new houses. As a result, existing homes become more valuable, contributing to price increases.
Example: A shortage of lumber and steel raises the cost of constructing new homes, causing buyers to turn to existing homes and increasing their demand and prices.
4. Long-Term Price Rises - Price Transmission
While we know that prices rise and fall in response to supply and demand, prices keep increasing over time. Why is that? One reason is price transmission, which happens when companies respond to changing material and labor costs. We all know that companies quickly pass on rising costs to consumers as material and labour costs increase over time. Price transmission is the additional cost that companies add to their goods and services to account for their own rising costs. As few will be surprised to hear, many of these companies are also slow to pass on a discount when their material and labour costs go down. So, prices go up, and they usually don't go down!
Example: After a shortage of lumber and steel raises the cost of constructing a new home, rising global interest rates cool off the overall demand for these resources. However, since the local demand for homes remains relatively balanced, developers are not pressured to drop their rising home prices when selling newly constructed homes. Thus, price transmission has added to the cost of a new home on the way up, but a lower price in lumber and steel doesn't necessarily mean home prices will go back down.
5. Long-Term Price Rises - Central Bank Policy
In addition to price transmission, central banks typically target for a low but steady inflation rate (i.e., 2% per year). This allows them to encourage a growing economy, where rising prices are manageable for consumers, but with a slight nudge to encourage them to spend, consume, and invest for today rather than wait for their dollars to be worth less tomorrow. For central banks, this is better than the alternative situation of deflation. Although deflation or prices going down may sound good at first sight, the problem is that this has the unintended effect of unwinding an economy. You may be planning to buy a new pair of sneakers. If we have negative inflation and you know that the price of sneakers will be lower next week, then you might be motivated to hold off on your purchase so you can get a lower price. However, if everyone is doing that, businesses will make fewer sales, people will continue to hold out for lower prices, people will lose their jobs because their companies are not bringing in enough revenue, people and businesses will have less money to spend, and economies will shrink. So, because deflation is so damaging, central banks use their policy levers to try and maintain steady but low inflation, and this causes home prices to rise.
Example: The Bank of Canada (BoC) has hiked interest rates multiple times to cool off inflation and bring the economy back into a manageable state. However, now that inflation is down below the target at 1.6% and unemployment continues to rise, the BoC realizes that it needs to stoke the economy's fires to avoid recession and potentially deflation. In response, the BoC has been steadily dropping interest rates to bring back consumer demand, and this is bringing home buyers back into the market. Long-term home prices will continue to be pushed higher as the BoC uses its financial tools to keep inflation growing home prices at a slow but steady rate.
Balancing Act: Inflation and Increasing Interest Rates
Despite all this talk about inflation, there's a catch – the one-two punch of inflation and increasing interest rates. If the central bank raises interest rates aggressively to keep inflation in check, it can chill the housing market. Higher mortgage rates mean higher monthly payments, which can deter potential buyers and exert downward pressure on prices. We saw this during the market cool-off in the last two years. The cost to own a home and maintain a monthly mortgage went up, and in response, the demand to buy a home went down. However, now that interest rates are declining, we may be on the other side where prices stabilize and continue to rise once more.
Navigating the Real Estate Landscape During Inflation
Inflation can be a financial puzzle, but as a savvy investor, you can thrive even when the economic winds are blowing toward rising prices. When it comes to the world of real estate, a few key strategies can help you navigate the terrain during times of inflation.
How to Invest During Inflation:
1. Note Investing:
Investing in mortgage notes can be a savvy move during inflationary periods. Here's how it works: Essentially, you become the lender. Instead of owning a physical property, you hold the debt associated with a property, and the borrower makes regular payments to you, including interest. As interest rates rise due to inflationary pressures, the interest income you receive from these notes can increase, making note investing an attractive option.
Example: Let's say you invest in mortgage notes with a variable interest rate of 5%. Over time, as inflation leads to higher market interest rates, these notes continue to generate a steady income stream. If market rates climb to 6%, your income from these notes also rises. This means you're preserving your purchasing power and benefiting from higher investment returns.
2. Rental Investing:
Owning rental properties can be a smart way to hedge against inflation. Here's the reasoning: Rental income often keeps pace with rising living costs. As inflation pushes up prices for everyday necessities, landlords can adjust rental rates accordingly, providing a reliable source of cash flow. However, keep in mind that there are strong renter rights in BC. That means there is a firm cap on how much landlords can raise rents locally on existing tenants. Otherwise, the only other option for landlords is to wait for their tenants to leave and then catch up to market rates at that point.
Example: Imagine you own a rental property that, in the past, covered your mortgage and expenses with a bit of profit. However, during inflation, the demand for housing increases, and tenants are willing to pay more for a place to live. As a result, your rental property's income covers your costs and generates surplus income due to increased rental rates. This extra income can serve as a buffer against the eroding effect of inflation on your finances.
3. Using Real Estate As An Inflation Hedge:
Historically, real estate has been a dependable hedge against inflation. While it's true that real estate markets can experience fluctuations, the combined potential for property appreciation and income generation often helps safeguard your wealth during inflationary periods.
Investors should note that while these strategies can be effective, they also come with their considerations and risks. For instance, selecting suitable mortgage notes or managing rental properties requires diligence and market knowledge. Additionally, real estate markets can fluctuate, and there are no guarantees of returns.
Conclusion: Navigating the Real Estate Sea During Inflation
Inflation isn't a monster under your bed; it's a financial reality we all must face. However, with proper knowledge and strategies, you can confidently navigate the real estate market, even during inflation. Keep in mind, though, investing in real estate isn't a one-size-fits-all solution. It demands careful consideration, market research, and a solid financial strategy. But, with the right approach, you can thrive in the ever-changing economic landscape.
Stay curious, stay informed, and keep exploring the world of real estate. It's a journey that can lead to financial stability and success, even when inflation comes knocking at your door.
Until next time, may your investments be wise and your real estate dreams thrive. Remember, it's not just a property; it's your anchor in the stormy sea of inflation.
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I am a Victoria-based local realtor with eXp Realty. My commitment to honesty, integrity, loyalty, and hard work have been essential pillars for me because they drive a high standard of excellent service for my clients. Helping you realize your dream is my goal!
I service Vancouver Island, but my focus is on Victoria, Sooke, Saanich, Malahat, Shawnigan Lake, Cobble Hill, Duncan, and the rest of the Cowichan Valley.
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