Recently, there has been a lot of talk and speculation in the news about the future of our monetary system in the United States. One expert predicts high inflation, another predicts deflation, and yet another predicts stagflation. While no one can predict the future, educated real estate investors should understand how real estate inflation works and how a high inflation market can affect their assets or debt.
The average rate of inflation in the United States over the last ten years has been 1.8%. This has been the average over the last decade, but many experts are now predicting higher-than-normal future inflation rates due to the economic effects of COVID-19. Businesses that have closed, people who have lost their jobs, and large injections of stimulus money from the federal government have set the stage for an unprecedented scenario.
What is inflation?
Inflation is defined as the average annual increase in the prices of a certain group of goods and services in a particular economy. In essence, it’s the gradual decline in the dollar’s purchasing power. The $400 washing machine you bought last year will probably cost you an extra $7.20 today, assuming an inflation rate of 1.8%. While that might not seem like much, adding up the costs of all your purchases over the course of a year including food, gas, phone bills, massages, etc. will result in a lot greater amount and a higher overall cost for things. It might have an even greater effect if a nation experiences inflation that is higher than normal.
How does it affect Rental Market?
Inflation has a significant impact on rental rates, which tend to rise in such circumstances. This is primarily due to an increase in demand for rental properties as a result of higher borrowing costs for funding property purchases. This, in turn, has a knock-on effect on rental rates due to increased demand for such properties. As a result, in an inflationary economy, more tenants are willing to pay higher rents rather than take out unmanageable mortgages.
Given the current economic situation and the economic downturn caused by COVID-19, the return of inflation appears unavoidable. The Reserve Bank of India (RBI) set the FY 2022 inflation rate at 5.3 percent on February 10, 2022, and it is expected to rise in the short term. Furthermore, as a result of reduced Omicron risks and easing supply chain pressures, core inflation may moderate. Understanding the mechanisms underlying this phenomenon is thus essential for navigating the real estate market and its effects on rising prices.
Real estate becomes an asset when it generates cash flow (via rents). Investors hedge or leverage the fact that inflation will benefit them because inflation is what drives up rents (paywall). Numerous studies have found that in the event of high inflation, rent will rise. As a result, cash flow increases.
Rent may even be more expensive than other commodities such as food and energy. Keep in mind: In general, there hasn’t been a significant decrease (paywall) in rental fees in a long time. And if you rent an apartment or a house, you’ll need insurance to protect your belongings—and the good news is that renters insurance is very affordable.
The property insurance policy of your landlord covers losses to the building itself, whether it’s an apartment, a house, or a duplex—but anything you own (furniture, electronics, jewelry, and the like) isn’t covered by your building’s policy. That’s why you need renters insurance. But while 95% of homeowners have homeowners insurance, only 41% of tenants have renters insurance.
The rise in Interest Rates
An inflationary economy, as a general rule, is never conducive to obtaining favorable loan rates for the buyer due to the higher cost of borrowing at such a time. This is partly due to the devaluation effect of inflation on the currency, which forces lenders to raise interest rates to cover losses due to declining currency value. When the financial regulator raises the reverse repo rate to combat inflation, it has a negative impact on floating interest rates for home loans, increasing the EMI outgo of home buyers whose loans are tied to such floating rates.
This increased borrowing cost affects not only the buyer, but also the developer because most construction companies/developers rely on such housing loans to complete their projects, and higher interest rates will result in higher property prices.
When interest rates rise, usually during periods of economic expansion, different asset classes react differently. Rising interest rates erode bond principal, affect the value of stocks and other financial assets, and influence debt interest payments.
