JPMorgan Chase CEO Jamie Dimon directly addressed inflation on a recent earnings call. He stated that, “inflation could be worse than people think,” and “I don’t think it’s only temporary.” Homeowners should pay close attention to Dimon’s insight, as a strong correlation exists between inflation and real estate values. As such, we’ll use this article to explain how high inflation impacts real estate investments.
Specifically, we’ll cover the following topics:
- What is Inflation?
- How Does Inflation Affect Real Estate?
- Is Real Estate a Good Inflation Asset?
- Are My Properties Worth More?
- Is it a Good Time to Invest in Rental Property?
- Will I Lose Money When Inflation Subsides?
- Final Thoughts
What is Inflation?
Technically speaking, inflation is the devaluation of money. In simple terms, inflation means the same amount of money buys less than it previously did. For example, say that you could buy a pound of bananas for $1 last year. But, this year, you need to pay $1.50 for that same pound of bananas. In this situation, your current dollars buy fewer bananas than they used to buy. Where $1 used to buy you one pound, that same $1 now only buys you two-thirds of a pound.
This phenomenon can have significantly negative effects on purchasing power. More precisely, if wages don’t keep pace with inflation, people can purchase fewer goods and services. Continuing the above hypothetical example, bananas experienced year-over-year inflation of 50%. If you also received a 50% wage increase, you wouldn’t notice this difference. But, in high-inflation periods, wages rarely keep pace with the rate of inflation. Accordingly, if your wages remained stagnant – or increased less than 50% – you would lose the ability to purchase as many pounds of bananas as you could in the past.
Real World Inflation
Yes, we used a hypothetical example about the price of bananas to explain inflation. But, currently, inflation is having major impacts in the real world. For example, Americans face far higher travel-related costs this summer than in years past. According to CNBC and the Bureau of Labor Statistics, the key government monitor of inflation:
For the 12-month period, used car and truck prices leaped 45.2%, while car and truck rental costs skyrocketed 87.7%. […] Public transportation, which includes airline fares, recorded a 17.3% jump year over year, while lodging away from home including hotels and motels saw a 16.9% year-over-year burst.
Put simply, traveling costs far more now than it did a year ago. Or, in terms of inflation, your current dollars purchase far less than they did last year.
How Does Inflation Affect Real Estate?
Inflation affects real estate in several keys – both directly and indirectly:
Rising Costs of Construction
In an inflationary period, building supply costs tends to increase. Lumber, concrete, steel, appliances, wiring, and all the other materials necessary to build a home cost more. For example, assume that, on average, all residential building materials have year-over-year inflation of 25%. Accordingly, a home that cost $200,000 to build last year would cost $250,000 to build this year.
If your wages (or savings) didn’t increase at this same 25% rate, this inflation would force you to build a smaller home than you could’ve in the past.
Rising Home Values
These increased costs of materials also have a direct impact on home values. Continuing the above example, assume you develop homes to sell. Last year, you could build a single-family home for $200,000. If you sold that same home for $240,000, you’d realize a 16% profit.
Alternatively, when you account for the effects of inflation, that same home now costs $250,000 to build. If you sold it for the same $240,000 price, you’d realize a 4% loss. Clearly, no developer – or business, in general – would willingly accept a 4% loss. Instead, they’d raise the price of the home. To realize the same 16% profit with the new home now costing $250,000 to build, the developer would need to sell it for $300,000.
And, residential home values largely depend on market comps. That is, at what price did similar homes sell? So, as developers raise prices to cover the increased costs of construction, market home values increase.
Increased Cost of Borrowing
Inflation can also indirectly affect real estate through increased borrowing costs. Traditionally, central banks (e.g. the Federal Reserve) combat inflation by increasing interest rates. When the Fed increases rates, a trickle-down effect occurs that mortgage rates also increase. And, when mortgage rates increase, it costs more to borrow money, meaning people can afford smaller mortgages.
For example, after reviewing your debt-to-income ratio, a bank determines you can afford a $1,500 monthly mortgage payment (principal and interest). Assuming a 30-year term, an interest rate of 2.5% would allow you to qualify for a $377,000 mortgage.
For example, let’s say the Fed increases rates, and mortgage rates rise to 4.0%. In this scenario, you could only afford a $311,000 mortgage with the same $1,500 payment. In other words, increased borrowing costs due to inflation reduced your home purchasing power by $66,000.
Is Real Estate a Good Inflation Asset?
Generally speaking, real estate serves as an outstanding inflation asset for the following three reasons:
Reason 1: Long-term Debt as an Inflation Hedge
30-year mortgages – the residential standard – offer some of the longest loan terms available in the United States. Finding a 30-year term business, loan, or personal loan is nearly impossible outside of a mortgage. This extended term provides an outstanding hedge against inflation.
In simple terms, inflation means that you make future loan payments with more inexpensive dollars. For instance, assume you secure a 30-year loan with $1,000 in monthly principal and interest payments. While the property tax and insurance portions of your mortgage payment will increase over time, the principal and interest will remain that same $1,000.
But, due to inflation, that $1,000 will be less valuable in the future. That is, in ten years, $1,000 will purchase far fewer goods and services than it does now. As a result, you effectively make future mortgage payments with more inexpensive dollars than when you secured the mortgage.
Reason 2: Inflation and Home Values
Due to the knock-on effects of increased construction costs, real estate values also tend to increase with inflation. For homeowners and real estate investors, this means that property portfolios increase in value over time, building personal wealth.
According to the Wall Street Journal, increases in residential real estate values have historically outpaced inflation in the United States. This means that, when your property values increase with inflation, your wealth still increases. For instance, assume year-over-year inflation of 5%. If your home value only increases by 4% during that same period, you effectively lose wealth. But, because home values generally outpace inflation, owning real estate builds your wealth, even in inflationary periods.
Reason 3: Protection from Rent Increases
Inflation doesn’t only increase the cost of goods. Rents also tend to increase significantly during inflationary periods. For example, a landlord may decide to increase monthly rent from $1,000 to $1,300 to compensate for other, inflation-related cost increases. When you own a home, you protect yourself from these increases. Due to the inflation hedge provided by long-term mortgages, home owners can avoid rising rents.
Caveat: Affordability Concerns
While residential real estate typically performs well during inflation, we need to offer a caveat on affordability. As stated, inflation typically translates to higher home values. For people who already own real estate, this value increase helps build wealth.
But, what if you don’t already own a home? For people looking to reap the benefits of real estate, inflation can make buying a home challenging. If your savings and/or wages haven’t kept pace with inflation, you’ll likely face huge financial barriers to entry. Unfortunately, for people on the outside looking in, buying real estate during inflationary periods is often impossible.
Are My Properties Worth More?
Residential home appraisers base values on market comps. That is, they look at the sales prices of similar homes in the areas to inform their appraisals. For example, assume that you hire an appraiser to determine the value of your 2-bed, 2-bath townhouse.
In your neighborhood, three other 2-bed, 2-bath townhouses sold in the last month for $210,000, $190,000, and $220,000. The appraiser would then look at the specifics of each home relative to your own to determine value. If higher quality, your home would likely appraise at or above the $220,000 comp. Conversely, a lower quality home would more likely appraise on the lower end of the comp spectrum.
Having outlined these procedures, inflation will clearly affect appraisals. When increased costs of construction drive up home values, new home prices increase. And, these increases spread through the market, as they become the comps upon which appraisals are based. Continuing the above example, say that next year another three similar townhouses sell. But, now they sell for $240,000, $260,000, and $265,000. The increased value of these comps in turn will raise your own property’s appraised value.
Is it a Good Time to Invest in Rental Property?
Generally, rental properties perform very well during periods of high inflation. In these situations, rents typically increase, meaning landlords can generate more income. And, this rent increase is compounded by affordability issues. Many people who cannot afford to buy homes must instead continue renting. This further drives up rent prices, as demand increases while supply remains largely unchanged.
However, affordability also poses a challenge to would-be real estate investors. As property values increase, it becomes increasingly difficult to buy a rental property. But, individuals considering buying a rental property should remember a real estate saying. Don’t wait to buy real estate; buy real estate and wait.
Rental properties are not short-term investments. Rather, they allow landlords to generate long-term wealth via three main profit paths:
- Cash flow from rents
- Loan amortization
- Property appreciation
Recognizing these profit paths, it doesn’t matter if a rental property seems currently overpriced. When you hold these assets for the long term, you will eventually earn a significant return on investment. In other words, with a long enough time horizon, future returns often justify slightly overpaying for a rental property now.
A “House Hacking” Alternative
Unfortunately, though, some people who want to buy rental properties now just can’t afford one. As an alternative, you can still gain some of the benefits of rising rents through a strategy known as “house hacking.” If you have an extra bedroom in your primary residence, you can still rent that to a tenant. In this way, rents help offset the mortgage on your primary residence. Or, you can use these rents to save for a down payment on a separate investment property in the future.
Will I Lose Money When Inflation Subsides?
It depends. In theory, when inflation subsides, the value of your real estate will also decrease. But, whether or not you lose money depends on if you actually realize these losses.
Realized vs. Unrealized Losses
When you own property (e.g. stocks, art, real estate, etc.), the value of that property will regularly fluctuate. For instance, say you buy a stock for $50. A week later, it may be worth $60 or $40. But, until you actually sell the stock, those gains or losses simply exist on paper. In technical terms, they are unrealized. Once you sell the stock, you translate the property into money, that is, realize a gain or loss. So, if you sell for $40, you have realized a $10 loss (i.e. lost money). Conversely, selling for $60 means you’ve realized a $10 gain (i.e. made money).
In real estate, this same phenomenon exists. If inflation subsides and your home value decreases from $300,000 to $250,000, you lose $50,000 in net worth. But, until you sell the home, you don’t actually lose any money. And, due to the long-term trend of increasing property values, homeowners should resist selling during market downturns. If your home value drops due to a pullback in inflation, just wait. Eventually, history suggests that the values will recover – and more – over time.
A Word of Caution
While property values generally increase over time, real estate investors should still take measures to avoid “underwater” mortgages. When you owe more on your mortgage than your home is worth, you are said to be underwater. When this happens, you cannot sell or refinance your property to pay off your current loan balance. This situation severely restricts financial flexibility.
You can avoid this sort of situation by maintaining higher levels of equity – or ownership – in your home. If you take an 80% loan-to-value mortgage, you finance 80% of the property and own outright the other 20%. This provides you a 20% buffer in case property values decline. That is, you have 20% equity in your home to protect against going underwater. Conversely, the more leverage (i.e. the higher the loan-to-value), the more vulnerable you are to fluctuations in home values.
Final Thoughts
Inflation certainly impacts real estate investments. As costs of construction increase, home values, in general, tend to follow. For landlords, inflation also drives rents higher, increasing a property’s income potential. And, when you combine this increased income with the inflation hedge provided by long-term mortgages, real estate is a great asset during inflationary periods.
But, while inflation can certainly affect real estate investments, subsequent tax planning doesn’t have to be a daunting task. At Shared Economy CPA, we live and breathe taxes for homeowners and real estate investors, so contact us to set up a tax planning strategy session!