Ways Inflation Affects the Real Estate Market
Inflation from January 2007 through December 2016 was extremely low, averaging only 1.77% per year in the U.S. and 2009 was actually negative (i.e. falling prices = deflation). Although 2017 has seen a bit more inflation it is still low by historical standards. In times of low inflation, inflation is a vague term that economists throw around when they’re trying to make one point or another. However, when inflation begins rising and hitting your pocket, the reality begins to set in. And it can have a quite noticeable effect on, not only the goods you buy at your favorite big box store, but even on real estate. Let’s take a quick look at some ways rising (or sinking) prices get their tentacles into that new house being built or the one for sale down the street.
Stop and think for a moment about the different materials go into building a house. This is an example where the final product is a sometimes less-than-obvious sum of its parts. A partial list would include wood, copper, concrete, glass, steel, etc. Do you notice a pattern? These are all basic commodities to one degree or another, and there are many more that go into a house before it is finished. When the prices of these basic materials go up, it costs your friendly neighborhood construction company more money to build a house. They can choose to either make less profit (not likely) or raise prices. Guess what they usually choose? So price inflation drives up basic materials costs making new houses more expensive.
Money Gets Expensive
Another effect of rising inflation is that interest rates rise due primarily due the the FED raising the Federal Funds Rate (i.e. the interest rate at which banks lend reserve balances to other banks overnight). The FED does this in an effort to quench the fires of inflation, Thus it becomes more expensive to borrow money. So fewer people are able to afford loans, which causes demand to drop and fewer houses to be built. In times when less money is borrowed, economic growth in general becomes suppressed.
A Shift Into Rentals
The higher cost of borrowing also tends to shift people into rentals rather than the home buyer market. Obviously, this is bad for single family residential sales but can be a boon for landlords, perhaps even motivating them to build more multi-unit structures. Plus unlike mortgages, rents can be raised to compensate the landlord for inflation thus affecting those who can least afford it the most.
Houses Provide Protection Against Inflation
As mentioned above, once you lock in your mortgage, as inflation cuts the value of each dollar, you are able to pay off your mortgage with ever less valuable dollars. In addition, since a house is a commodity, it tends to appreciate pretty much in sync with rising inflation. So although owning a home won’t make you rich it does provide some protection against rising prices. Unlike your personal home, investing in income producing Real Estate however, can make you rich by getting your tenants to pay off your mortgage. The one caveat where a mortgage can bite you during rising inflation is if you have an “Adjustable” mortgage where your mortgage payment can be increased due to rising interest rates.
What Do Foreclosures Have to Do With It?
Follow this chain of logic and you’ll understand why an increase in foreclosures is another result of inflation. We’ve already discussed how growing inflation makes everything you buy more expensive. Let’s say a family has a mortgage they can barely afford with prices the way they are. Throw higher prices for food, gas, and all of life’s other basics into the mix and suddenly they’re having to choose between eating supper or paying the house note. This is how waves of foreclosures start like we had back in 2007. It is also a time when lenders become more predatory in their willingness to approve loans. It is something that borrowers have to be very careful about. And another reason we caution you against Variable (or Adjustable) mortgages.
The focus here has been rising prices, which we call Price inflation which is commonly the result of “Monetary Inflation” (i.e. an increase in the money supply). Though inflation is much more common than its opposite, known as deflation – or sinking prices – there have been a few short instances of the latter in recent memory. At first, it seems that dropping prices would be a good thing. The problem is that it is usually associated with sinking demand brought on by high unemployment or by a contracting money supply due to a market crash. In the long run, it’s not a good thing for the housing market since it can result in falling housing prices as well. And once people see that they owe the bank more than their house is worth many end up defaulting on their mortgage which in turn increases the supply of houses on the market thus driving house prices down even further.
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