Is real estate a good hedge for inflation?
Real estate is often considered to be a good hedge against inflation. In this post we'll talk about whether this is more dogma or settled science.
Inflation 101:
Inflation is the rate of increase in prices over a given period of time. It quantifies the relative reduction in purchasing power, or in other words the overall increase in cost of living in a country over time.
Let's say inflation is hovering around 5% per year and I want to buy something today for $100. Let's call it a candle.
Now, let's say that I take out $100 in cash from the bank and proceed to decide that I don't need a $100 candle. I end up forgetting about this $100 bill in my wallet for a full year, at which point my desire to buy this highly overpriced candle has reached its apex. I decide to treat myself and return to the candle store with images of deep relaxation filling my mind, all of my problems melting away as the scents of lavender, sandalwood, and eucalyptus fill the air.
To my chagrin, the price of the candle has increased to $105. As it's been sitting in my wallet, the purchasing power of my original $100 has gone down by $5. That's inflation.
What's the link between real estate and inflation?
With the right strategy, investors can minimize the impact of inflation on the value of their money. So why is real estate often cited as a component of a good strategy to hedge against inflation?
Real estate prices are inherently connected to inflation
As prices rise, generally, so do property values and rent. This means that if you have a property that produces rental income, you'll be able to mitigate the impact of increased prices with increased operating income from rent. This can help balance increased costs of maintenance and repairs and help you maintain a stable net operating income (your monthly profit).
What's important to remember here is that inflation can be caused by a variety of factors with varying impacts on real estate. If price increases are primarily driven by increasing input costs (materials, construction, labor etc.) without an associated increase in demand (more renters/buyers), it may be hard to increase rent to sufficiently account for inflation. This type of inflation ("cost-push") may however result in increased property values (it costs more to build) which can help balance some of the reduction in purchasing power.
If prices are increasing due to strong economic growth and a demand which outpaces supply ("demand-pull"), we would expect rent prices and property values to increase.
Rapidly increasing population has resulted in a housing shortfall in Canada of millions of units, which means that supply will continue to outpace demand for the foreseeable future.
Real estate is a tangible asset
Unlike stocks and bonds, whose value is more susceptible to rapid changes in consumer sentiment, real estate is a tangible asset with intrinsic value in the form of land and buildings. The land itself has value because of its location, and potential uses. Buildings and infrastructure have value based on their construction quality, functionality, and ability to generate income or provide services.
Considering location, economic outlook, and optimizing the usage of your real estate investment will help reduce the erosion of purchasing power caused by inflation.
The verdict
While real estate isn't a miracle cure for inflation, there are many arguments to be made about the value of having real estate in your portfolio to help weather economic conditions present during a period of inflation. However, investment decisions should always consider the current state of the economy and likely future trends.
What does this mean for the current economy?
The most recent Statistics Canada update reported the inflation rate at 2.9%. While this was lower than the 3.4% annual rate from the previous month, it was still short of the 2% target. A big reason for this was due to shelter costs. Due to the continuing shortfall of supply on the housing market, demand for real estate hasn’t been as heavily impacted as the rest of the economy to historic interest rate hikes from the Bank of Canada.
The conventional macroeconomic wisdom in tackling a higher-than-desired rate of inflation would be to continue to raise interest rates to discourage spending, thereby reducing demand and driving down prices. This would put further strain on a housing market where owners have been squeezed by the fastest rise in mortgage interest costs in history.
The good news for property owners is that the solution to the current situation seems to break from conventional wisdom. At 1.5%, inflation is well below target when you remove shelter costs from the equation.
Bank of Canada Governor, Tiff Macklem acknowledged the limits of monetary policy on real estate prices saying, “That is not something monetary policy can fix.” His comments echo the intuitive logic that while interest rates can have an impact on real estate demand through higher costs of ownership, they cannot solve the shortage in supply.
According to experts, it seems that the Bank of Canada is positioning themselves for another rate cut in the second quarter, even if inflation is above the target. This would ease the interest rate burden on home owners.
What do you think the Bank of Canada should do to combat persistent high inflation in real estate?
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* Disclaimer: Guiker provides information for educational purposes only and does not offer investment advice. Individuals are responsible for their own investment decisions and should consult a qualified financial advisor before making any investment choices.