[Editor's Note: In this post, WCI Network partner Passive Income, MD explains how real estate provides a long term hedge against inflation. You know how you can make real estate an even better inflation hedge? Leverage it with fixed interest rate debt. Now you're winning against inflation on both sides of the ball. Just beware of deflation! Enjoy the post. ]
One of the common phrases heard in real estate circles is that investing in real estate is inflation-proof.
I thought I’d take a look at why that might be.
First of all, what exactly is inflation?
Inflation is simply the rate at which the price of goods and services rises over a period of time. This can be detrimental for you, as the value, or purchasing power, of your money diminishes.
In other words, if you could once buy bread for $2, it might now cost $2.50. If milk was $3, it might now cost $3.50.
Your dollar’s purchasing power diminishes over time. Does anyone remember when you could buy a soda for 50 cents?
In essence, although the number on the bill in your wallet hasn’t changed, it’s losing value just sitting there.
Why does inflation happen?
I have to start out by admitting that I am not an economist. I took a few courses on macro and microeconomics in college, but I am in no way an expert on the subject.
One big thing I do remember from back then is the concept of supply and demand. This is one of the most fundamental concepts of economics, and the main governing force behind pricing.
Supply and demand are linked, and when one outpaces the other, there is a change in the economics, or the pricing of a product or service tends to shift. This can ultimately lead to inflation.
To dig into it a bit, the most common reason for inflation is what economists refer to as ‘demand-pull inflation’. It occurs when demand outpaces supply. This leads to a willingness on buyers’ parts to pay higher prices for a highly desired product or service.
For example, imagine the scenario where the demand for a certain car is through the roof (maybe due to awesome new technology at a good price), but there’s not enough made for everyone to have one. People who really wanted the car might then be willing to pay even more to get their hands on it. You had better believe the car manufacturer will figure out a way to increase the price of it to meet that demand!
There’s also something called ‘cost-push inflation’ that occurs when demand remains the same, but the supply diminishes. An example of this is whenever there has been a shortage of oil, gas prices in this country skyrocket.
People also debate whether an increase in the printing of money causes inflation. The thought is that as you release more paper bills into circulation, the value of each of them decreases.
There have definitely been times in history when certain countries have tried printing money to revive their economy, and the result has been something called ‘hyperinflation,’ where the value of the currency plummets.
How is inflation measured?
Inflation isn’t completely static. Every year it’s different, but over the last 100 years, it’s averaged a bit over 3% per year. In the last decade though, it’s averaged a bit over 2%.
So how is it most commonly measured?
Well, the US Bureau of Labor Statistics uses a metric called Consumer Price Index (CPI) to track it. It is the measure of the average change in the prices paid by consumers over time for a basket of goods and services.
These things include tracking prices of food, transportation, and health care, to name a few.
Is inflation always a bad thing?
Well, Ronald Reagan once spoke these words, “Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.” Makes it seem like inflation is a pretty nasty character.
However, economists say that some inflation is not necessarily a bad thing because it forces people to not just horde their cash. If the value of it is diminishing, people will put that cash to use. It encourages some spending and investments, and that helps to grow the economy.
Who controls inflation?
In this country, it’s the Federal Reserve that controls inflation.
“The central focus of what we are doing at the Fed is to keep inflation from accelerating – and preferably decelerating.” – Alan Greenspan
Without getting into the weeds, they use monetary policy to control inflation, prevent deflation, and try to help promote a stable economy.
Why is real estate inflation resistant?
Different economists, like Shiller, have tracked housing prices as an investment over time:
Through his studies and countless others, they’ve shown that housing prices over the last 120 years have followed the rise of inflation if not exceeded it.
That’s because, along with many other products (like bread and milk) mentioned before, housing isn’t a luxury, it’s a necessity. So people will spend money for housing. And just like the prices for those products will rise over time, so will the cost of housing.
We all know that appreciation of the value of a real estate investment is only one way real estate investors make money. They also make money through monthly cash flow. This is calculated by taking the income (rent) minus expenses.
Well, as inflation and the cost of goods goes up, so do wages to match. As wages increase, so does the cost of rent. So as a property owner, you’re able to increase rents to fall in line with inflation. That’s part of the reason if you’ve been a renter, the cost of rent seems to increase at least 3% each year.
If you took out a loan to purchase your home or a rental property, there’s a decent chance you used a loan at a fixed rate. If so, the appreciation of your house value may be increasing in line with inflation, however, your fixed rate payments will stay the same. You might be making a monthly payment of $5000 for 30 years, but in those later years, that $5000 that you’re still paying is actually worth less as a result of inflation.
So as you can see, there are multiple reasons why real estate can provide a reliable hedge against inflation, and another added benefit of investing in real estate.
Any other reasons that real estate is inflation resistant? What other things are inflation resistant?
Do you feel ready to learn more about real estate? WCI's No Hype Real Estate Investing course is the best on the planet. Taught by Dr. Jim Dahle and more than a dozen other experts, this course is packed with more than 27 hours of content, and it gives potential investors the foundation they need to learn about all the different methods of real estate investing. If you’re interested in real estate investing, you can’t afford to miss the No Hype Real Estate Investing course.
Featured Real Estate Partners
Nice post. Recommendation for a future one, how real estate investments respond in a recession.
Caveat – there are people making the decisions behind every asset class who buy and sell
Since real estate – usually non multifamily – is in part determined by the psychology of the seller and buyer, I think one cannot discount the person in addition to the asset
Real estate doesn’t do anything in recession – people do by their decide to buy or sell the asset
Just Sayin
Yes, real estate keeps up with inflation on average. The real return is minimal over the long haul though.
The real benefit of inflation with real estate is when debt is used. Personally I hate debt. But inflation favors the debtor since they pay what they owe with “smaller” dollars.
Inflation is from “too many dollars, chasing after too few goods.” Monetary policy is the biggest lever. Since coming off the gold standard in 1971 our fiat currency is a matter of a printing press.
I’m not an economist either. Neither was Reagan who got a C in economics in college. But I like his Armed Robber description. Your inflation graph doesn’t go back far. If you go back to 1900 you will see several times where CPI topped 10%. I lived through one or two of those and it wasn’t pleasant. I still have my WIN (Whip Inflation Now) pin. Does anyone remember those?
The best ways to beat inflation in my opinion: 1. Keep working since salaries tend to keep up. 2. Invest in equities since they tend to exceed inflation, not just match it like real estate.
the trouble comes when people extrapolate this to their own doctor mc mansion. Luxury homes may not offend so well in poor economic times when you need their value the most. however most rental properties and average single family homes likely do keep up with and possibly outpace inflation.
Saying the Fed “Controls” inflation is a little misleading. It’s more like the Fed does its best to anticipate, react to, and influence inflation. And sometimes the Fed really has a great effect. But sometimes the other forces acting on the economy exceed the effects of the tools that the Fed can wield.
Wow, I’ve never seen the housing chart before. Quite the history breaking run from 1997 through 2005.
Does the inflation proof aspect refer only to increasing asset value?
It seems like real estate would easily exceed inflation when rental cashflow is included. Rental income is rising with inflation while the cost of maintaining the asset (loan payments & interest) is dropping. Maintenance costs are also rising, but those are usually a relatively small portion of the overall costs.
High returns are the main inflation “proof” benefit. If you really want inflation PROOF, then buy TIPS. But assets with high returns such as stocks, real estate, and small businesses, where the businesses can increase the price of their goods and services (and rent) with inflation, are pretty good in inflationary times.
Such a nice post on what inflation is all about!