Why invest in real estate when there is inflation?
The year 2022 hasn’t been the greatest for the UK market with the rising costs of living alongside a depreciating Pound Sterling. In recent months, rising inflation rates have led to the increases in cost of living, leaving many Britons with a lot less money to save – and much less for making new investments.
However, we’re here to tell you that you shouldn’t hold off on making real estate investments, even now with rising inflation rates. But, before we discuss all the reasons why you should consider investing, especially in real estate, during times of inflation, let’s first discuss about what exactly inflation is and what causes it.
What is inflation?
In layman’s terms, inflation refers to the rise in prices for goods and services. On the other hand, the rate of inflation describes the speed in which these prices increase – usually by percentage points (%). When there is inflation, the purchasing power of the people will decrease, meaning that there will be less things that you will be able to afford per £ spent.
According to the International Monetary Fund (IMF), inflation can be used to describe both the increased prices of goods as well as the increased cost of living within a country. In the UK, both factors describe the current state of inflation. But what exactly causes inflation to happen?
The causes of inflation
To many ordinary people, inflation might look like an invisible force that seems to rear its head from time to time. In reality, inflation is an economy’s immune response to a number of things that happen within that economy. Learning what inflation is and, more importantly, what causes it to happen can help everyone take the right measures to shield themselves from it – such as investing in real estate.
With that said, there are four main causes of inflation. Either one of these is enough to cause the rise in prices that defines inflation. However, a combination of any of these factors can cause a worsened state of inflation or, at the very worst case, cause an economy to go into recession. Let’s discuss the four causes of inflation:
1. Imbalance between supply and demand
Strong customer demand for a product or service can lead to price increases, a phenomenon known as “demand-pull” inflation. When widespread demand across an economy rises, prices for such goods tend to rise alongside it. Short-term supply and demand mismatches don’t usually cause alarm, but high and sustained demand can cause demand-pull inflation and drive up prices across the economy.
When unemployment is low and incomes are increasing, consumers are more likely to spend money. Increasing consumer spending during a period of economic growth is one factor that might fuel a surge in demand for goods and services.
However, the supply of a commodity usually falls when its price rises because of the law of supply and demand. According to the principle of supply and demand, prices rise when there are less of a good or service available and higher demand from customers. This leads to price increases caused by demand-pull inflation.
2. Rising production costs
When costs of production such as labour and materials rise, prices will rise as a result of this, causing a “cost-push” inflation rather than demand-push. As production costs rise, there is no change in the amount of goods demanded, but there is a decrease in the amount of goods available. The effect is higher pricing for consumers because of the increased cost of production.
The prices of crude oil and metal going up tend to be a possible indicator of cost-push inflation because they are used so extensively in manufacturing. For instance, if the cost of steel goes up, building manufacturers may decide to charge more for their wares since steel is an essential ingredient to their products. The company will pass the increased cost of raw materials on to customers if product demand is unrelated to the demand of steel. Consequently, consumer prices rise without corresponding changes in demand.
The price of goods produced is affected by many factors, wages being one of the most significant. A labour or worker shortage may emerge if the economy is doing well and the unemployment rate is low. In response, businesses have had to raise wages in order to compete for skilled workers, driving up the cost of manufacturing. When a corporation passes on salary increases to consumers in the form of higher prices, it will also lead to a cost-plus inflation.
3. Increased money supply
According to the US Federal Reserve, an increase in the money supply means an increase in the total amount of currency in circulation. The risk of inflation, and in particular of demand-pull inflation, arises if the growth in the money supply outpaces the growth in production.
When there is too much money in circulation, financial institutions such as the Bank of England will raise interest rates in attempts to remove the excess cash from circulation. However, a rise in interest rates can lead to inflation, since borrowing becomes more expensive and companies will push that increased cost to consumers. The idea is that when inflation occurs due to increased money supply, once all the excess money is removed from circulation, interest rates will fall alongside the price increases. Sometimes this tends to be the case, but, unfortunately, sometimes it isn’t.
4. Lack of preventive economic policies
Without strong economic policies, any sudden or intense movements in the market can cause a country’s economy to falter. That then causes a ripple effect which can cause a depreciation in the country’s currency as investors start to lose confidence in that country’s economic growth. There are many kinds of economic policies that governments can implement to shield or at the very least soften the blow of any incoming inflation.
Although inflation is primarily a monetary policy issue, the government and other policymakers can help bring it under control by increasing economic production and productivity. Higher levels of economic output will help keep inflation in check by bringing back the balance in supply and demand curves. Governments could also implement a contractionary monetary policy to control the money supply. One way to do this is by withdrawing specific paper money or coins out of circulation.
How a UK real estate investment trust invests in times of inflation
Real estate investment trusts, or REITs, are companies that finance, operate or owns income-generating real estate. They invest their capital into a diverse array of property assets and projects which have the potential to generate handsome returns to their investors. Think British Land Company, Shaftesbury and even Big Yellow Group.
In a nutshell, REITs will purchase property using a mixture of equity and debt either for rental purposes or to sell at a later date. Apartment complexes, data centres, healthcare facilities, hotels, infrastructure (in the form of fibre cables, cell towers, and energy pipelines), office buildings, retail centres, self-storage, timberland, and warehouses are some examples of the types of properties that may be included in the portfolio of a REIT.
According to Nareit, REITs have the ability to provide natural protection against inflation. This is usually due to the parallel rise in rental rates and real estate value during times of inflation, which supports REIT dividend growth. The rise in rental prices also mean that REITs are still able to provide a steady income stream to their investors, even during inflationary periods. This is something that most other forms of investments cannot provide.
REITs have proven time and time again that they are a great cushion against periods of inflation over the last twenty years. For example, when inflation was at its highest point over the last 40 years back in 2021, REITs had outperformed the S&P 500 stock market index by a whopping 13 percentage points.
Keys to real estate investment in times of inflation
Putting money into the real estate market can seem like a risky bet right now, but history shows that doing so can be an excellent financial buffer over the course of a longer period of time. If you’re considering investing in real estate during these inflationary times, whether directly in property or through REITs, there are a few things that you need to keep in mind in order to make successful investments.
Here are the main things to keep in mind when making a real estate investment during inflation:
1. Do your homework
The importance of doing your own homework is extremely important, regardless of type of investment you intend to pursue. When it comes to real estate investing, however, there is quite a bit more digging that should be done before putting in money for a property or investing into a REIT.
If you’re considering buying a private property on your own, there are a few things that you need to check before you put a downpayment in. Here’s a rundown of the key details you’ll need to know as you look into potential investment properties:
- Investment purpose
- Profit opportunities
- Age of property
- Condition of property
- Overall housing market
If you want to invest in real estate but feel more comfortable investing in REITs, there are a separate list of things to consider before picking a REIT to invest in. Here’s a quick checklist of things to ask yourself before investing in a REIT:
- Is the interest cover more than four times (4x)?
- Is the net property income increasing consistently?
- Is the REIT’s gross revenue increasing consistently?
- Is the distribution per unit of the REIT increasing consistently?
When it comes to investing, the saying “don’t put all your eggs in one basket” cannot be more true. And, as you may have gathered, the same definitely applies to making real estate investments. The ups and downs of different markets can be used to your advantage by spreading your investments across multiple regions to reduce risk in the event of a sharp decline in one market. If all of your real estate investments were concentrated in one area and that area had a downturn, the value of your whole portfolio would plummet.
3. Don’t borrow
As we’ve mentioned before, inflation tends to also mean a rise in interest rates. When interest rates are higher, the cost of borrowing is higher, meaning that you’ll have to pay more on any money that you borrow – including mortgage payments. If you’re planning to make an investment in private real estate, make sure that you pick a property that is within your means. But, if you’re considering investing in REITs instead, never take out a loan in order to purchase more dividends.
When you borrow during times on inflation, the amount of risk on your investments will double. Regardless of whether your investment thrives or fails, ultimately you’ll still need to repay the loan and any interest that would certainly be attached.
How to Profit From Inflation?
There are only a few kinds of investment that act as inflation hedges, which can help ease monetary burdens as the cost of living increases due to inflation. Much like most forms of investment, there will always be a certain amount of risk attached, but these three UK inflation cushions are most likely to help keep you afloat whenever there is inflation in the market. More often than not, these types of investments can even generate profits while most others aren’t.
So, consider protecting yourself (and profiting) from inflation by investing in these assets:
- Commodities like gold or silver
- Value stocks
- Real estate!
How to invest for inflationary times?
Although you might be hesitant to invest right now, there are definitely ways that you can protect yourself and your wealth from future bouts of inflation. If you’re considering investing right now during this inflationary period, highly consider investing in real estate – at the very least look into REITs. Not only will it protect your wealth now, it will also help remove your cash from depreciating in value over time as it sits in its savings account – which is the worst thing to do during inflation.