Inflation and real estate: What does inflation mean for real estate?
With inflation, your money loses its previous purchasing power and loses value. This happens when money is put into circulation more often, as was the case during the financial crisis in 2008 and is now repeated during the Corona crisis. The central banks print new money, which ultimately results in the existing money having less value, regardless of its form (cash or bank deposits).
Inflation thus mainly affects monetary values. But what about material assets?
First of all, we must remember that tangible assets are not equal to tangible assets. In our article Equities vs. real estatewe have already dealt with the topic of asset inflation real estate. Both shares and real estate are tangible assets. In principle, shares offer protection against inflation, but since the stock market is subject to very strong fluctuations, investing in securities is a more speculative matter.
A property can compensate for a rising inflation rate by increasing rental income at the same time, so that security-loving investors could concentrate more on yield properties. Thus you make yourself independent of inflation.
In the long term, real estate investors enjoy a significant increase in value. But how can it be that some assets gain in value and others lose?
The secret lies not in the spice, but in the scarcity of a good. Scarce goods are goods whose resources are limited. These include gold, oil, real estate, etc.
Inflation and scarcity: oil as a scarce resource
Resources cannot be exploited and multiplied indefinitely, so that a higher price can be achieved than for free goods, which are available indefinitely. An increasing amount of money is distributed over the same amount of goods as before the increase in money supply. The consequence: Increasing values of goods such as real estate and stocks.
Coronavirus and real estate
The coronavirus has thrown the whole world into crisis. Anyone who has invested in monetary assets must now tremble or may already have suffered a major loss.
The situation for real estate owners looks much more relaxed. Certainly, individual distress sales have caused the price level to fall in the short term. There is already very high demand for income properties on the real estate market again, and the price level in A-locations is completely unchanged or has even risen compared to the pre-crisis level:
Source: Variant Perception Research 2021
And in the medium to long term, a recovery of the real estate market and thus an increase in the price level can be expected.
Real estate debt and inflation
Debt is bad. Many of us grew up with this "knowledge". However, one must differentiate between good and bad debts, especially when it comes to real estate.
The purchase of a yield property, for example, only makes sense if you use the leverage of outside capital. In practice, this means that you take out a bank loan to finance your Real estate for purchase. However, the monthly loan instalments are not paid by you, but (indirectly) by your tenants.
Now the question is how real estate loans behave in inflation. Basically, during an inflation the prices and thus the interest rates of your credit increase. If you have concluded a good financing agreement, a long fixed interest period applies and you have nothing to fear at first (e.g. 10, 15 or even 30 years). However, if this fixed interest rate expires, interest rates could rise sharply and your loan will become more expensive.
However, as already mentioned, prices are also rising. This means that you can also demand a higher rent for your property. So in this scenario, the tenant would cover the additional costs of your loan with the increased rent.
In addition - and this is the great advantage of leveraged property during inflation - you can now pay off the loan much more easily, because the loan amount does not change, while the attainable rent is now much higher. This means that the loan can be repaid in a much shorter period of time, e.g. with special repayments.
Investment recommendation for real estate to protect against inflation
Whether real estate offers protection against inflation depends very much on how you use the property.
Many Germans want to fulfil their dream of owning their own home. They buy a property, live in it and bequeath the house or apartment to their children at some point. During an inflation, however, this scenario develops negatively, as both the interest rates on loans rise and the maintenance costs. The owner must therefore pay on top.
Only an investment property offers you this security. No other investment opportunity can probably protect you so well against inflation. The cash in the safe is losing more and more purchasing power, stock markets are collapsing or moving sideways and speculative objects such as art or cars represent a high risk even without inflation.
Deflation Impact Real Estate
Supply and demand determine the price of a good (the principle of the free market economy). If supply is greater than demand, prices fall. This is called deflation. Accordingly, deflation also affects real estate, as its value falls. If many properties are offered but only a few are in demand, prices fall. In addition, the price level for rents, salaries and goods falls.
However, the loan taken out must be repaid at the old conditions, which can be a particular challenge for homeowners and is not always possible. Therefore, this is not a favourable scenario for investment properties.
But governments and central banks want a deflationary situationavoid at all costs. Japan can be mentioned as an example: In order to combat deflation since 1990 (triggered by the bursting of a financial bubble), the Bank of Japan is countering this with massive orgies of money printing. The target is an inflation rate of 2%.
Should a similar crisis affect Germany, the measures would look very similar. As the owner of a Investment property a good starting position. More on this in the next paragraph.
Japan Deflation Real Estate
How far will prices fall in the event of deflation? We can answer this question using Japan as an example.
Japan has been struggling with deflation since the 1990s. When the financial bubble burst, prices plummeted. The Japanese stock index Nikkei collapsed, real estate loans could no longer be repaid and many banks had to file for bankruptcy. The labour market was also affected and unemployment rose enormously.
The Japanese government has tried to revive the economy by taking on new national debt - but without success.
The share index fell from around 40,000 to 16,000 points and many properties were suddenly only worth half of the original purchase price. Thanks to the measures taken by the central bank, however, the deflationary tendencies could be kept in check - real estate is currently rising significantly in value again and is no longer so far from its 1990 values.
Inflation 1923 Real estate
In 1923 Germany experienced exactly the opposite - namely hyperinflation. With hyperinflation, the price level rises extremely fast, at least by 50% per month (that would be a whole 13,000% per year!). At that time people transported their money in wheelbarrows or travel bags and tried to exchange it for goods as quickly as possible, as the money was losing value day by day.
While an egg still cost 7 pfennigs in 1912, the value of an egg rose to 2.1 million paper marks in September 1923, to 227 million in October and finally to 320 billion in November. As a result, the government decided on a currency reform in the same month, which made all assets, but also debts, worthless from one day to the next.
Anyone who owns investment property at such a time is fully protected from the devastating effects of hyperinflation.
Hyperinflation in Germany: hundreds became trillions.
Conclusion and outlook
The corona crisis is currently raising the question of whether we can now expect renewed inflation. Or do we possibly have to fear deflation?
Experts expect the inflation rate to continue to fall in the second half of 2020. In the long term, however, the effects of the crisis cannot be determined. However, it is assumed that the global economy will recover and the inflation rate will return to a normal level. But the danger of higher inflation due to the global money-pressure orgies of central banks is also a not unlikely possibility. Especially since measures must be stepped up more and more to ensure the debt service of indebted states, companies and households. Stronger inflation of several percentage points would thus be a not unlikely scenario - against which investors in yield property are hedged.
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