Inflation is one of the biggest concerns for investors. This is because inflation rates can affect different assets in different ways. As a prudent investor, it is important to understand inflation and the effects it can have on various assets. Today, we will explore inflation and talk about its effects on real estate.
What is Inflation?
Inflation is a continuous increase in the prices of services and products in an economy over a period of time. In other words, inflation is an increase in the prices of all products and services – not just a few. This increase in prices implies that for every unit of currency spent, fewer goods and/or services can be purchased. Hence, inflation leads to lowering the purchasing power of money invariably impacting the demand and supply of such goods/services. Usually, with the growth of an economy, consumers and organizations spend more money on buying goods/services. In a typical growing economy, the demand is usually more than the supply of goods. Therefore, sellers raise the prices leading to inflation.
Inflation is measured by tracking the speed with which the prices of a basket of products increase in a given period of time. In the UAE, the Federal Competitiveness and Statistics Authority (FCSA) collects around 334 different categories of services and goods, and calculates the cost of this bucket to arrive at the Consumer Price Index (CPI), also called headline inflation.
Impact of Inflation on Real Estate
In the UAE, housing and utilities have the highest weight of around 34%. In addition to it, the impact of inflation is on the purchasing power of people and also there are many ways in which inflation impacts real estate.
Also Read: Benefits & Risks of Real Estate Crowdfunding
Cost of Materials
Construction of a building involves a wide range of materials like steel, wood, copper, glass, concrete, etc. In an economy, if there is inflation, then the prices of all these materials would increase too. Further, labor will also be available at higher rates. This means that the construction company would spend more to build an apartment complex. In order to offset the additional costs, the developer increases the sale price of the house. Therefore, inflation makes new houses more expensive reducing the supply of new constructions. This invariably leads to an increase in the price of existing houses.
Another setback of inflation is that commercial banks start increasing the interest rates. This is because inflation corrodes the value of money, hence lenders increase the interest rates to make up for their loss. However, this also means that borrowers, who are already facing a tough time meeting costs (due to increased prices) are expected to pay more interest on their housing loans. Add to it the increase in the price of properties, buyers are skeptical about buying new properties.
Talking about developers, there are many developers who rely on bank finance for the completion of their projects. With loan rates increasing, they experience an overall increase in the cost of construction and have to increase the price of the ready units to cover up for their losses.
Since the cost of borrowing increases, people tend to rent a property rather than buy one. Also, the landlords can always increase the rent to compensate for the rate of inflation. Since the demand is more (as many people avoid purchasing property in rising inflation), tenants are willing to pay a little extra rent rather than bear the expensive home loan.
With the landlord’s perspective, this has a positive effect on the price of the property. A house generating higher rent is usually sold at a higher price as compared to the one that doesn’t.
How buying a house can protect you against inflation?
Think about it. During inflation, the prices of all products and services increase too, including the prices of properties. Therefore, once you buy a house on a mortgage at a fixed rate of interest, every year, you actually pay less (since the money devalues with inflation). Also, the price of your property increases to make it a win-win situation for you.
Real estate investors, who purchase a property with the purpose of leasing it get the best deal. They purchase a property on mortgage and immediately lease it to tenants. The rent received by them is used to pay off the installments and by the end of the loan tenure, they virtually have the house (with its increased price) as an addition to their portfolio with minimal investment.
Something for Investors
With the evolution of options like Real Estate Investment Trusts (REITs) and Real Estate Crowdfunding, investing in real estate has become easier even for the small investor. While most investment plans target to achieve inflation-beating returns, investing in real estate can truly be a great way to allow your money to grow with inflation.
Like other products and services, inflation certainly has an impact on the real estate sector. However, many long-term property investors find inflation to work to their advantage since it allows them to fetch a higher rent and selling price. It is important to assess your investment goals and time horizon carefully before entering the real estate sector. You might talk to a financial advisor about the same.