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Tuesday, April 28, 2009

Real Estate & Inflation

Inflation's Effect on Housing

[Note to Readers: please also see the update to this piece, posted Oct. 20]

One of the big questions in the (financial) air is whether all the money that's been pumped into the system (the various TARP's, the Fed Reserve's serial loan guarantees, government purchases of bank equity, etc.) the last six months or so will ultimately be inflationary.

In turn, that begs the question: if in fact inflation is on the horizon, how does that affect real estate?

Traditionally, anything that makes paper money (currency) less valuable makes hard assets more valuable. And assets don't get any harder than real estate.

Another factor that cuts in real estate's favor is the effect on debt as money becomes less valuable.

Because mortgages are calculated in constant ("nominal") dollars, repaying a fixed debt with increasingly cheap dollars benefits borrowers. If everything doubles in price, your $50k -- or $500k -- mortgage suddenly becomes smaller by comparison.

The key is whether "everything" includes wages.

"Crowding Out" Effect?

If wages increase along with the general cost of goods and services, real estate comes out ahead.

However, if static wages must be spread over household expenses bloated by inflation, it stands to reason that there will be less left over to spend on housing.

Diminished purchasing power spells weaker housing demand . . . which means lower housing prices.

Of course, one of the principal tools to fight inflation is raising interest rates. Because more than 80% of the money used to buy housing is borrowed, more expensive money equals more expensive housing. To correct for that, housing prices would have to fall.

So how do all of the foregoing factors net out?

If you're keeping score, two benefit housing, two harm it.

Call it a draw, 2-2.

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