How Will Inflation Affect Real Estate Investing?
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Originally Posted On: https://www.dohardmoney.com/how-will-inflation-affect-real-estate-investing/
Since the onset of the COVID-19 pandemic, the US Government has pumped trillions of stimulus dollars into the economy. Naturally, this has people asking me: Ryan, how will inflation affect real estate investing?
Inflation occurs when prices increase primarily due to an increase in the money supply (i.e. the dollars in circulation). Typically, if the cost of construction materials increase, an increase in real estate values and rents will also occur. As such, real estate usually performs well with inflation.
In the following article, I’ll dive into more details about real estate and inflation. Specifically, I’ll cover these topics:
- What is Inflation?
- How Does Inflation Affect Real Estate?
- Inflation and Rental Real Estate
- Inflation and Wholesaling
- How Inflation Affects Fix & Flips
- Final Thoughts
What is Inflation?
If you’ve read or listened to financial news lately, you’re likely aware of concerns about inflation. But, what exactly is inflation? In technical terms, inflation refers to the devaluation of money. Conceptually, inflation means that you can buy less with your money now than you could earlier. This phenomenon traditionally results from an increase in the money supply. In other words, if you add more money to the economy than it can absorb, these extra dollars will drive up prices – there’s simply too much money in circulation.
For instance, assume that last year you could buy a gallon of milk for $1. But, now, you need to pay $1.50 for that same gallon of milk. In this situation, you’re dealing with 50% inflation when it comes to milk. That is, the cost of milk has increased 50% year-over-year.
While only a hypothetical example, inflation like in this milk scenario can significantly affect your purchasing power. I only used a single good – milk – here. But, inflation is usually measured in terms of baskets of related goods and/or services. Consequently, individual items don’t tend to experience inflation in isolation. Rather, inflation ripples throughout the entire economy (though it generally affects certain items more than others).
Returning to purchasing power, assume that your wages didn’t keep pace with inflation. That is, in the year-over-year stretch that the cost of milk increased 50%, you didn’t experience an associated 50% increase in wages. Accordingly, you can now purchase less milk than you could a year ago. Even if your wages increased at a rate of 25%, you’d still find yourself in a worse financial position. And in the real world, with inflation affecting the bulk of an economy’s goods and services, this loss in purchasing power – understandably – concerns people.
In normal times, the US economy experiences 2% to 3% annual inflation. When rates exceed that, economists – and everyday Americans – begin to worry about the negative effects of inflation. And, from an investor’s perspective, people want to know about the best places to protect themselves from inflation.
Historically, real estate has been an outstanding asset class during inflationary periods. This means that, even in eras of rising prices, real estate investments usually perform well. For investors, this reality brings to mind a wise saying I often repeat: don’t wait to buy real estate; buy real estate and wait.
How Will Inflation Affect Real Estate Investing?
Now that I’ve provided an overview of inflation, in general, I want to focus on how it affects real estate specifically. In the above example, I discussed inflation with respect to a gallon of milk. In the real world, inflation drives up the costs of construction materials (e.g. lumber, steel, wiring, plumbing, etc.).
When construction costs increase, the housing market usually sees an associated increase in A) home values, and B) rents. In the current environment, two factors in addition to inflation have helped drive these increases as well. Currently, high demand for housing and low supply of available homes, low interest rates, and inflation have all combined to drive up values and rents. These increases have made real estate a great investment.
Having said that, I want to briefly expand upon the central impacts inflation has on real estate.
Impact 1: Increased Costs of Construction
In a traditional inflationary environment, massive cash infusions into the economy drive up the costs of construction materials. For example, assume that an economy has $10 total. If the only goods in that economy were five rolls of copper wiring, each of those rolls would be worth $2. Now, if another $10 were added into the economy, those rolls of copper wiring would increase to $4 each.
Obviously, this is an extremely simple example. But, the point I’m illustrating is that an infusion of cash into the economy – like we’ve seen during the COVID-19 pandemic – can drive up the costs of construction materials. And, when construction material costs increase, the costs to build a home increase. For example, assume that an economy sees a 25% year-over-year in inflation. This would mean that a home that cost $200,000 to build last year now costs $250,000 to build.
Impact 2: Increased Home Values
These increased construction costs have a knock-on effect on home values. In residential real estate, home values are determined by market comps (i.e. the recent sales prices of similar homes). When developers incur higher costs to build a home, they need to sell that home for a higher price to collect the same profits.
For example, let’s look at the above home. Last year, it cost $200,000 to build. If the developers sold it for $230,000, they’d collect a 15% profit. However, this year it now costs $250,000 to build. If they sold a house that cost $250,000 to build for $230,000, they’d take an 8% loss – something no business would willingly do. Rather, by increasing the sales price to $287,500 on top of $250,000 in construction costs, the developers would still collect their original 15% profit.
As the sales prices of new homes increase due to scenarios like this, the increase in values spreads throughout the entire housing market – new and pre-owned alike.
Impact 3: Increased Rents
This inflation-related increase in home values directly affects rents, as well. When real estate investors purchase rental properties, they first need to analyze cash flows. In basic terms, this means ensuring that the monthly cash in exceeds the monthly cash out. When you purchase a home for more money due to increased values, you need to take out a larger mortgage. This leads to larger monthly mortgage payments.
Now, the cash required to cover your monthly costs increases. Translation: you need to increase rents. For example, say that a rental property used to have $500 in monthly operating expenses and $500 in mortgage payments for $1,000 in total monthly cash outlays. In this situation, $1,200 in rent still leaves a landlord with $200 in cash flow. But, what if, due to increased home values, that same landlord purchased a home with a $700/month mortgage? Now, $1,200 in rent only breaks even. To collect the same $200 in monthly cash flow, this landlord would need to increase rent to $1,400.
When this phenomenon occurs across the entire market, you see economy-wide increases in rent as a result of inflation.
Inflation and Different Real Estate Investing Strategies
In this section, I discussed broad impacts of inflation on real estate. Moving forward, I’ll discuss inflation in terms of different investing strategies. Depending on what strategy (or strategies) you pursue, inflation will impact your real estate investments slightly differently.
Inflation and Rental Real Estate
Rental Real Estate Overview
By rental real estate, I mean the umbrella of strategies that include entering into a long-term lease with a tenant. This could include the more traditional buy and hold strategy, where investors purchase a home – usually at retail price – and immediately lease it. Additionally, this could include BRRR investors, people who first rehab a house before refinancing it and renting it to a long-term tenant.
When it comes to rental real estate and inflation, investors should keep in mind the tangible nature of real estate. That is, regardless of what’s happening in the economy, real estate exists and people need to live somewhere. When the costs of certain goods and services increase due to inflation, people may choose to buy less of them – or none at all. But, people cannot opt out of a place to live – they always need to buy or rent homes, regardless of inflation.
For investors, holding rental real estate during inflationary periods means you can profit from this reality. While I certainly don’t advocate price gouging, investors can – and should – increase their rents in accordance with inflation. You may not want to exceed the rate of inflation, but with rental real estate, you can at least hedge against the negative effects. That is, by raising rents in conjunction with inflation, you can ensure that your investment does not suffer.
Additional Consideration: Mortgages as a Hedge Against High Inflation
As a related benefit, the mortgages used to finance rental properties provide an incredible hedge against inflation. 30-year mortgages – the residential standard – offer close to the longest loan terms available to borrowers. And, these long-term rates allow you to lock in principal and interest payments at today’s rates that you’ll eventually pay with tomorrow’s dollars.
For instance, assume you sign a 30-year mortgage that calls for $1,000 in monthly principal and interest payments. While the escrow portion of your mortgage payment will increase with time, this $1,000 portion will remain the same for the life of the loan. But, in ten years time, inflation will make $1,000 worth far less than it is today. As a result, with each passing year of inflation, you’ll make your mortgage payment with “cheaper” dollars, making long-term mortgages on rental properties an outstanding hedge against inflation.
Inflation and Wholesaling
How Wholesaling Works
The wholesaling investment strategy lets you make money without needing to actually purchase properties. As a result, it represents a great approach for new real estate investors working on gaining experience.
As stated, with wholesaling, you don’t purchase an investment property. Instead, wholesalers find off-market properties, and they enter contracts to purchase these properties. Rather than close on the purchases, they assign the contracts to a third party, typically a fix & flip investor. And, they assign these contracts for a fee. As such, wholesalers find deals, connect the sellers with investors, and collect a fee in the process – all without dealing with the headaches of doing any rehab work themselves.
When you wholesale, you learn very quickly how to spot good deals for fix & flip investors. If you don’t find good deals, you won’t be able to assign contracts to these people. Simply put, you learn what to look for in a property.
As an investing strategy, wholesaling has very little risk. When you find a property to put under contract, you can add a clause stating that, if you can’t find someone to whom you can assign that contract, you can exit the deal.
So, if you have major concerns about values going up and down due to an inflationary environment, wholesaling can reduce your exposure. Say you put a property under contract for $100,000 and want to assign it for $105,000, collecting $5,000. If fluctuations in value mean you can’t meet that $105,000 assignment goal, you can walk from the deal. Simply put, with wholesaling, you always have an exit option.
How Inflation Affects Fix & Flips
Fix & Flip Overview
As a fix & flip investor, you need to understand everything wholesalers do about finding good deals. But, you also need to understand how to rehab and sell these properties. Broadly speaking, the fix & flip strategy works like this:
- Step 1, Find a distressed property: Investors need to find properties that need rehab work to qualify for traditional financing. And, these properties need to make financial sense. That is, the purchase price and all rehab-related costs need to be less than the projected final sale price to make a profit.
- Step 2, Rehab the property: After purchasing a distressed property, house flippers need to renovate it to a standard that A) qualifies for a traditional mortgage, and B) appeals to potential buyers in that particular market. This requires an in-depth understanding of renovations, working with contractors, and creating accurate rehab budgets.
- Step 3, Sell the property: Finally, house flippers need to sell the property. Typically, these investors sell to primary homebuyers. That is, they sell to people looking to buy their home – not an investment property. This requires an understanding of sales and pricing strategies, and a solid analysis of the local market.
With fix & flip deals, one of the largest risks an investor faces involves market fluctuations. When you use hard money loans to finance a flip, the lender bases those loans on a property projected after-rehab value, or ARV. If the actual sale price comes in lower than this ARV, flippers can take a serious loss.
As a result, investors could possibly face a bad situation where they need to buy a distressed property and the associated rehab/construction materials in a period of inflation, but they sell after that inflationary period retracts. In simple terms, you overspend then undersell, leading to a loss. As discussed, though, home values typically increase in inflationary periods. And, these increased values should more than compensate for the increased purchase and rehab costs.
But, let’s say that, for some reason, home values collapse following an initial period of inflation. Now, you can’t flip the property and cover your costs. While this is an unlikely scenario, you always have a way to deal with this risk: convert your fix & flip property into a rental. That way, rather than sell the renovated property at a loss, you continue to collect rent payments until home values rise again.
In general, real estate investments perform well during periods of inflation. Yes, inflation drives up the costs of construction. But, for investors, inflation also tends to increase A) home values, and B) rents. And, even if your real estate investments don’t exceed inflation, they will likely stay even with it. As a result, real estate serves as a far better hedge against inflation than, say, leaving your cash in a low-yield savings account.
But, to actually get your foot in the real estate investing door during inflationary periods, you’ll likely need to find off-market properties. Unfortunately, properties on the MLS are priced at retail. And, due to inflation, these retail prices are often cost-prohibitive for investors. With off-market properties, you can still find outstanding deals – even when inflation has driven prices through the roof. And, to help you close these deals, we’ve put together a motivated seller checklist – basically a script for what you need to say in a conversation with a potential off-market seller.
If you’d like a free copy of this motivated seller checklist, just text your e-mail address to me at 435-294-0433.