Inflation frightens most people because the cost of everything is going up. However, inflation has benefits for real estate investors whether it is your primary residence or investment properties. That doesn’t mean a real estate investment will help with the cost of gasoline and groceries today, but it can build long-term wealth. And… today offers a unique short-term window of opportunity for real estate investments.
How Inflation Erodes Buying Power
As we all know, inflation decreases our ability to pay for goods and services when everything becomes more expensive. The basic concept is that when wages remain steady, but goods become more expensive, we can afford to purchase less. A primary driver of inflation is the basic “supply and demand” curve. As demand increases, prices also increase if there is not an excess of supply. Right now, demand is high because interest rates are low, which makes it less expensive for people to purchase everything they wanted. This is on top of the stimulus money that was pumped into the economy to stimulate demand. And it is all magnified by supply chain bottlenecks that have limited supply. High demand with limited supply is the perfect recipe for inflation.
The most useful tool the Federal Reserve has for controlling inflation is higher interest rates. This is key to the unique window of opportunity that real estate currently has in this time of inflation.
Specific to real estate, inflation is going to drive both higher mortgage rates and higher property values. Even if the pace of construction picks up, new construction (supply) will be more expensive due to inflation. This may all sound like unwelcome news for both buying a primary residence or expanding an investment portfolio. And it probably will be once the higher interest rates kick in. However, inflation is a borrower’s best friend and a debtor’s worst enemy. Hence, a short-term window of opportunity exists while interest rates remain low but inflation is high.
Inflation will be driving up property values, but today’s low-interest rates will become cheap money as long-term debt is devalued due to future inflation.
How Inflation and Real Estate Work Together
Inflation will accelerate the rise of home prices, but the decreasing loan-to-value of mortgage debt is a natural discount. This happens because the equity in the property increases while your fixed-rate mortgage payments remain the same. This is a natural occurrence with most mortgages, and it becomes exaggerated in a good way when interest rates are low with a high inflation rate. An example of a natural occurrence is a $100,000 home that was purchased 10 years ago with a 30-year mortgage and a corresponding $470 monthly payment. Today, that home is probably worth $360,000 but the payments will remain the same for another 20 years. In comparison, a person paying $360,000 for a home today will have a mortgage payment of $1,650. Everything else being equal, inflation has put an extra $1,180 in the pocket of yesterday’s homebuyer every month in comparison with today’s buyer (or $14,160 every year). An amount of money that will continue increase for the next 20 years until the mortgage is paid off in full.
However, everything being equal would require that tomorrow’s mortgage rates remain as low as today’s. Locking in today’s low-interest rates (before they go up) is going to amplify that inflation-beating rate of return. It gets even better…
Inflation is a Wealth Multiplier for Down Payments
Borrowing money is about using other people’s money to build wealth. A mortgage is other people’s money. When you put down only 15% to buy a property, you get a return not just on that 15% but also the other 85% because of appreciation. We don’t know exactly what the rate of appreciation and inflation will be, but historically these are close to 5% for appreciation and 2% for inflation. The difference in those numbers is key to building wealth with other people’s money.
For example, if you put down $50,000 on a $330,000 house, the appreciation over 20 years will give it a value of about $876,000. If you subtract out the loss of value due to inflation, that $330,000 home will be worth about $471,000 in today’s dollars. Your net gain will be $141,000 in 20 years. That’s for a primary homeowner. For investors with a rental house, the wealth multiplier becomes much more substantial. Investors will earn the appreciated value along with 20 years of cash flow to pay off the $330,000 mortgage, plus rent increases will cancel out the effect of inflation. Essentially, an investor can expect that $50,000 to obtain the full $876,000 over 20 years.
Today’s low-interest rates will further amplify the down payment multiplier. Real estate is one of the very few places where you can lock in a 30-year interest rate. Next month (or next year), the interest rate will be higher to compensate lenders for the rate of inflation. A higher interest rate means higher monthly payments which will reduce your total gain over the next 20 years. You’ll gain all the appreciation but less of the inflation multiplier.
The way you maximize the inflation edge today is by locking in a low mortgage rate for the next 30 years before interest rates rise.
Inflation Limits Most Investment Growth
Many people see building wealth as adding to their savings account or 401k retirement account. But these are highly susceptible to inflation and are slow to grow. Two factors have the biggest effect on this slow growth. First, neither of these accounts increases in value due to appreciation. So that entire segment of growth is wiped out compared to real estate.
Next, banks don’t pay saving accounts more interest than what they loan money for, or they would go out of business. Regardless of the inflation rate, you aren’t likely to earn more than about 0.06% on savings before inflation. When inflation is included, you’ll lose money overall.
With a 401k, it’s reasonable to expect an annual return of 6% – 7%. That will earn you an accumulative rate of return between 3.5% – 4.5% against a historic 2.5% inflation rate. But there is a kicker to that. That is only on the money you have in the investment. With real estate, you only need to make a small down payment to earn 100% of the profit. That means 85% of real estate earnings come from other people’s money. For example, a $50,000 investment in a 401k at 7% would become $193,000 in 20 years. By using other people’s money to invest the same $50,000 in a $330,000 house, that $50,000 can be expected to become $471,000 (or $876,000) in 20 years.
Bottom line, high rates of inflation and appreciation are beneficial for property owners. But today’s limited window of opportunity is locking in a low mortgage before inflation leads to higher interest rates.
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Author bio: Brian Kline has been investing in real estate for more than 35 years and writing about real estate investing for 12 years. He also draws upon 30 plus years of business experience including 12 years as a manager at Boeing Aircraft Company. Brian currently lives at Lake Cushman, Washington. A vacation destination, near a national and the Pacific Ocean.