Beating Inflation

Every piece of inflation news has the power to terrify and send investors searching for ways to protect wealth.  Bonds look like a poor prospect.  As the Federal Reserve (Fed) raises interest rates, bonds will lose value simply as a matter or arithmetic.  (For an explanation see this post.)  Even if the Fed were to cease its counter-inflationary effort, bond yields would rise anyway, and prices accordingly would fall, as lenders insist that returns at least compensated them for the declining value of money.  As rates and yields rise, stock prices will decline, because interest rates factor into calculations of a share’s fair value and because rising rates as well as the inflation itself will raise uncertainties about future profits.  (For more detail on these points, see this post.)  

Only real assets, commodities and especially real estate, have a chance of keeping up with inflation, and if history is any guide, outpacing it.  Three lines of reasoning support the real estate solution:

  1. The price of land and structures should rise with the general rise in prices on everything else that people consume.  To be sure, inflations never lifts all prices at the same pace, but the rate of gain universally tends to accelerate, and that holds true of real estate. 
  2. Home ownership can fix the cost of at least one part of the household budget, and an important part at that.  While inflation is playing hob with all other costs in life, from filling one’s gas tank to buying groceries or a new suit of clothes, homeowners know that their basic cost of shelter will remain more or less constant, locked in so to speak whether the house is owned outright or is supported by fixed-rate mortgage.
  3. These two natural attractions create a third support for real estate investments.  By driving people into this area, home prices tend historically to outpace inflation and by a wide margin.  Of course, that fact goes hard with late buyers, but this reality makes real estate especially attractive for those who are already in place or can get into place quickly.  The last great inflation of the 1970s and 1980s offers ample evidence.  Between 1970 and 1990, the consumer price index in this country rose 6.2 percent a year on average.  During that same time the median price of a house sold in the United States rose from $23,900 to $125,000 an increase of 8.6 percent a year and a real return on investment of 2.4 percent a year, better than most any other option open to investors.

Remarkably, increases and decreases in mortgage rates during this time failed to change this fundamental pattern and likely will not this time either.  To be sure, rising mortgage rates discourages buying, but instead of sending buyers out of the market, rising financing costs prompt eager buyers, eager to get into the real estate haven, to trade down and buy a smaller less well-appointed property instead of simply giving up the inflation protection of ownership.  Again, the experience of the last great inflation illustrates.  Fixed mortgage rates rose from about 7.3 percent in 1970 to a high of over 13 percent in 1985.  For those who owned their houses outright or had their mortgage rates locked in, this meant nothing, but it mattered a lot to prospective buyers.  After all, the cost of supporting a mortgage had risen almost 80 percent.  Yet, as indicated earlier, home price appreciation continued.  People, rather than give up, shifted where they focused across the price distribution.  

The same thing seems to be happening again.  Mortgage rates have risen from 2.7 percent early in 2021 to 3.6 percent early this year to almost 5.5 percent at last measure.  That is more than doubling, albeit from an inordinately low level.  Yet the median sales price of a home during this time has risen almost 16 percent.  No doubt, the steep rise in the cost of supporting a mortgage has affected buyers, but, as before, it is prompting them to shift what they are buying rather than halt the upward price pressure by walking away from the market altogether.  Last December, when mortgage rates were still low and inflation concerns were just budding, a disproportionate number of sales occurred at the higher end of the price distribution.  While the median home price stood at some $360,000, fully one-third of home purchases nationwide occurred at over $500,000.  Only 29 percent of national purchases occurred at prices near the median.  But with the rise in mortgage rates, people began to trade down in the price distribution.  As of June, some 63 percent of the purchases occurred at prices closely clustered around the median price.

Though no sane person would look for a precise replay of history, the reasoning that prevailed in the last experience with inflation remains valid and there is nothing in the present that would impede it from having effects similar to the past, if not exactly the same.  Real estate, residential real estate in particular, remains an inflation haven for those who are in or can get in.  For those who cannot buy, there is the option of real estate investment trusts (REITs).  (For more on this investment vehicle, see this post.)  These will give the investor exposure in real estate, if not the direct budgetary relief of home ownership (point 2 above.)  There are others – such as commodities futures or put options on stocks – but unlike direct real estate investments or REITs, they impose more burdens and risks on the investor and demand more investment sophistication than is common. 

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