Are you interested to know why real estate investment is such a strong hedge against high rates of inflation? If so this is the right article for you.
What is Inflation?
Inflation is the term used to describe an increase in prices over time. The rate at which prices increase over time is called inflation. Most governments measure the rate of inflation in their country on a monthly basis. They do this by measuring the increase in the price of buying a ‘basket’ of goods on a monthly basis and the % proportion that the price goes up or down is known as the Consumer Price Index (CPI).
What are the Rates of Inflation Around the World?
Most counties around the world have recently experienced very high levels of inflation over the past 12 months as the world’s economies come back on-line following shutdowns post COVID 19.
What is Causing High Inflation?
There is not one specific reason which is causing the current high rates of inflation around the world. High rates of inflation are being caused by multiple factors including :
- Increased Demand – many economies have been dormant as residents have been forced to stay at home during the Covid restrictions. This significantly reduced the consumption of goods and services. However, as residents have been allowed to return to normality most economies have seen spikes in demand as residents again consume goods and services.
- Supply Chain Shortages – as economies around the world open up following economic shutdowns due to Covid-19 restrictions, demand for goods and services has spiked. Many manufacturers and companies have struggled to increase production levels to meet demand. The mismatch between demand and supply has put upward pressure on prices.
- Staff Shortages – Many employees have returned home during lockdowns and have not returned to where they previously lived. In addition, many people have simply chosen a change in a career completely or leave the employment market altogether.
- Energy Costs – spikes in demand for oil, gas, and other energy have put significant pressure on global energy prices which is a critical component of production in all sectors of the economy.
- War in Ukraine – Russia’s invasion of Ukraine has created economic concerns as well as shortages of grain, fertiliser, oil and gas. Ukraine has struggled to supply goods to the global market and economic sanctions have been imposed on the Russian economy.
- BREXIT – the UK’s withdrawal from the European Union has caused significant trade friction which has increased prices.
What is an Inflation Hedge?
An inflation hedge is an investment that protects the investor against the decreasing purchasing power of capital (cash) that results from the loss of its value due to rising prices. Investors looking to hedge against inflation typically purchase assets that are expected to maintain or increase their value over a period of anticipated high inflation.
Real Estate as an Inflation Hedge
Real estate has been long been considered a significant hedge against inflation, this is because of two principal reasons:
- Rental Growth – as the rate of inflation increases, landlords are able to pass on part or all of these costs to tenants. This allows them to maintain their return on a relative basis. In many markets, because the supply of new property typically declines with high levels of inflation, the pool of available rental stock also reduces putting even more pressure on rents.
- Increases in Capital Values – high rates of inflation increase the costs of materials and labour for the construction of new properties. These costs are passed on by developers in the form of higher prices for new properties. Which in turn pulls up the price of a second-hand stock in the property market.
What makes real estate investments hedge inflation?
In the last two years, growing asset prices have stimulated a purchasing frenzy for anything from stocks to Non-fungible Tokens (NFTs) and cryptocurrencies. On a global scale, inflation has not been this high for 40 years.
Real estate has long been observed as a hedge against inflation. Real Estate does not correlate strongly with stocks, bonds, and stock market trends. During periods of high inflation, we expect to see rents rise along with the cost of raw materials and labour.
The main factor in explaining why real estate creates a hedge on high inflation rates is attributed precisely to the landlords’ ability to increase rents in markets with low vacancy rates.
Do higher rents influence inflation?
If you observe the 50 largest US and European cities, landlords primarily benefit from rising rents. This is because many real estate sectors have experienced lower than average vacancy rates in the last few quarters, allowing landlords to respond to demand and raise rental prices.
The correlation between real estate and inflation
There is no definite cause-and-effect relationship between real estate and inflation. Inflation is mostly regulated through consumer prices. In contrast, real estate bases its prices on property supply, demand, construction of housing, and general demographic trends.
However, inflation and housing tend to correlate over a more extended time, given the impact wages and interest rates have on real estate. Typically, inflation raises salaries and increases people’s ability to rent or purchase property For over 100 years, housing has shown a similar fluctuation rate as inflation. So, since salary averages tend to increase with inflation, some experts draw a link between housing prices and inflation.
Furthermore, inflation usually happens in markets that have low-interest rates, which is currently the case in the US and some countries in Europe. Since borrowing and applying for credit financing is so accessible, these markets also experience a raised demand for rental, commercial, and residential properties. As people look for a stable market for investment in times of economic uncertainty or fluctuations, real estate is an alternative to investing in the stock market.
How might inflation affect you?
If you are looking to sell a house, right now is the time to do so because it is still a seller’s market. Some estimates predict that home values on a global scale will skyrocket by 14% on average until November 2022. It will lead to a growth in home prices in the US market, particularly since the number of homes for sale is rapidly shrinking. So, home-sellers in hot real estate markets will also be able to raise the value of their homes through negotiations.
However, some negative effects brought on by inflation will also be felt in the real estate sector. Since the cost of building materials has been increasing over the past two years, new housing will also become more expensive. Developers and house builders will compensate for their losses by passing on the increasing costs to the consumer. But despite this trend, real estate investment is a strong hedge to high rates of inflation in today’s economic climate.
Important notice: Proptech Pioneer and its associated companies seek to provide investors with guides, information and tools, but we cannot guarantee this information to be accurate or perfect. You use the information at your own risk and accept no liability if you rely on this information. Proptech Pioneer is not a tax advisor, accountant conveyancer, lawyer, financial advisor or mortgage advisor. You should seek independent advice from independent professionals before making any investment decision.