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With inflation running hot, real estate is a refuge

Real estate investing

Federal Reserve chairman Jerome Powell and his colleagues raised short-term rates by 75 basis points on June 15 in an effort to cool inflation, which has exceeded 8 percent for several months running, the highest in 40 years.

Further rate hikes are expected through 2022, and the overnight lending rate is expected to settle at about 3.4 percent by the end of the year. That would suggest another 1.75 percent in total rate hikes, spread across the four scheduled Fed meetings this year.

Higher rates will increase the cost of borrowing for items like credit cards, car financing, and adjustable rate mortgages.

Mortgage rates have risen along with inflation, with the rate on a 30-year fixed mortgage rising to near 6 percent. As recently as December, the rates on 30-year loans was just over 3 percent.

Higher rates, coupled with pandemic-fueled price increases, have caused affordability issues in some of the high-flying markets around the country. Inflation and higher rates appear to be dampening demand in some markets, though a lack of inventory is likely to cushion any major price dips. 

Few experts predict that home prices will fall substantially, even as the Fed raises short-term rates and sells off some of its balance sheet to bring inflation under control, which the Fed chief says is a top priority.

“Restoring price stability is an unconditional need — it's something we have to do,” Powell said at a conference on May 17. He called price stability “the bedrock of the economy.”

 Many economists said the Fed waited too long to address inflation, but Powell was concerned about attaining full employment in the economy. Wages have risen, and many employers have complained about trouble finding workers.

U.S. employers added 390,000 jobs in May and the unemployment rate remained steady at 3.6 percent.

As inflation spikes and the Fed weighs easing its bond buying, interest rates on mortgages remain low and opportunities for investors persist. (Getty Images)

As inflation spikes and the Fed weighs easing its bond buying, interest rates on mortgages remain low and opportunities for investors persist. (Getty Images)

How is real estate a hedge against inflation?

Investing in real estate offers a couple of advantages during inflationary periods, and this recent runup is no exception. And there is scads of evidence that a diversified portfolio, one that has 20 percent or more invested in real estate, offers strong and stable returns. 

Doug Brien, the CEO of Mynd, believes an inflationary environment creates more opportunities for investors in the SFR market. 

“It’s an attractive option because rents are bound to rise along with inflation,” Brien said, which increases the cash flow for property owners.

As rates rise, demand for rental homes is likely to increase as well, he added. 

“If it becomes more expensive for potential buyers to finance a purchase, fewer will be able to afford it,” Brien said. “This will increase demand for single family homes and create more upward pressure on rental prices.”

The old adage is that real estate acts as a hedge inflation, and there are a number of reasons for that, including:

  • Housing prices rise with inflation, so owners will see appreciation. With the country some 3.8 million units short of demand according to Freddie Mac, upward pressure on prices means that longtime owners have already seen the value of their assets increase more quickly than at any time in recent memory. 
  • Mortgage payments do not change over time, but inflation means the money paid back in the future is worth less. As equity grows, fixed-rate payments stay the same.
  • Rents on single family homes have been on a steady upward swing over the last two years, and inflationary pressures have hit the rental market as well.

How do mortgage rates correlate to inflation?

Short-term inflation generally has little impact on mortgage rates, which are more closely linked to the 10-year Treasury bill, where rates tend to rise slowly.

The interest rate the Fed controls is what banks and credit unions use to lend to each other overnight. This is a very different lending market than the one for mortgages, where banks compete with one another for business.

The rate on the 10-year T-bill was creeping above 3 percent in early June. In March, it was hovering over 2 percent, but as recently as early December the yield was at 1.35 percent.

Mortgage rates have been following the Treasury bill, rising steadily since the end of last year. For most of 2021, 30-year mortgages could be had for around 3 percent, and refinance activity was robust as many homeowners rushed to take advantage of the lower rates.

Mortgage lenders and banks are starting to trim staff to respond to the fall in demand for loans and refinancing.

Many observers expect mortgage rates to settle around 5 percent, and economists point out that number still qualifies as historically low. (While the 30-year rate has typically stayed below 10 percent since 1971, it did spike to 18.53 percent in October 1981.) 

As rates for primary residences rise, the impact on borrowing for investors in the single family residential (SFR) sector is softened by the fact that they’re already paying higher rates. And owning property brings with it numerous benefits. 

“Even in this crazy environment, it’s still a relatively safe investment,” said Dennis Bron, vice president of growth for Mynd.

SFR investors earn cash from collecting rent, and owners who buy and hold are able to employ several strategies to reduce their tax burden, writing off many expenses associated with a rental property, and taking depreciation on a home.

Inflation hit 6.2 percent year over year in October, its highest rate since 1990. ( Bureau of Labor Statistics)

Inflation hit 6.2 percent year over year in October, its highest rate since 1990. ( Bureau of Labor Statistics)

Concerns about jobs drove Fed policy

For most of 2021, Powell and his colleagues at the Fed expressed their concerns about the job market, and were reluctant to make any moves that would prevent the economy from reaching full employment. (The unemployment rate was 3.8 percent in February; it peaked at 14.7 percent in April 2020, the height of the pandemic.)

Frederic Mishkin, a Columbia University professor and former Fed governor, said in December that the economy had already reached full employment and the Fed was “much too optimistic on the inflation front,” and distracted by its focus on the labor market.

Mishkin said then that he feared the Fed would have to raise rates higher than it would otherwise need to if it had acted earlier.

“The Fed is behind the curve,” Mishkin said in an interview with CNBC back in December. “The reality is that inflation is higher than they anticipated and it’s more permanent than they anticipated.”

Professor Mishkin was prescient, as the economy has hit the highest inflationary levels since the Reagan Administration.

Housing market’s rise preceded inflation surge

The increase in home prices started before the inflationary pressures of the last year, as a shortage of homes, and the pandemic-fueled migration to the suburbs and smaller cities, spurred bidding wars and double-digit-percentage hikes in many cities. 

These increases are hitting families looking to buy in the SFR space, as well as investors, a group that now includes some deep-pocketed institutions like JP Morgan, Blackstone and the Toronto-based investment firm Tricon Residential, which plans to invest $5 billion in single family rental homes in the U.S. in partnership with Teacher Retirement System of Texas and Pacific Life Insurance Company.

John Burns Real Estate Consulting estimated that some $45 billion in institutional money flowed into the SFR and build-to-rent sectors in 2021.

“A lack of inventory is really jacking up home prices,” said Don Ganguly, senior vice president of Mynd Investment Management. With investors forced to pay higher prices because of the increased demand and the looming increase in rates, they are “not getting as much juice month-to-month with cash flow.”

Many observers of the housing market are trying to figure out the direction the market will take as a different scenario for mortgage rates settles in. Cities like Atlanta, Phoenix, Raleigh, Charlotte, Tampa and Austin saw double digit percentage increases in prices over the last year, and experts see a flattening in prices, if not a small drop off, in some places. 

For those already in the SFR market, these have been heady days as equity has increased with higher home values. And many experts believe that there are still good opportunities, if investors do their homework and find properties that have potential.

“Rental housing demand is going to continue. Some percentage of people are going to work out of their houses for some period of time,” Ganguly said. “A lot of those people may not want to buy, so you are going to have a spillover from the apartment rental cohort who are looking for a home in the rental market.”

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