Did you know that real estate is a hedge against inflation? Let us take a look at how and why inflation occurs and what happens to the property sector during periods of inflation.
Defining inflation
Inflation is the increase in the prices of goods and services over time. Just like what we are presently enduring, the erosion of our buying power means that the same peso today is buying less. This event will continue in the coming months.
I just rented a car at AVIS in Chicago this week and saw the conversion rate at P58+ to a dollar. That is almost a 20 percent devaluation of our currency vis-a-vis the US dollar.
From eating out at restaurants to purchasing grocery items to buying real estate and even investing in the stock market and beyond, inflation has always played a major role for consumers and investors alike. This is because as prices rise over time, the buying power of our peso slowly diminishes. The fact that a peso buys less as time goes on is one reason why fuel costs more, groceries are up and, depending on interest rates, property prices can also move up.
Major causes of inflation
Inflation can be caused by multiple factors, and demand-pull and cost-push inflation are among the most common.
Demand-pull inflation happens when the demand for certain goods and services is greater than the economy’s ability to meet those demands. When this demand outpaces supply, there’s an upward pressure on prices, causing inflation.
Meanwhile, cost-push inflation is the increase of prices when the cost of wages and materials goes up. These costs are often passed down to consumers in the form of higher prices for those goods and services.
However, the causes of inflation this year are a bit more complex and have been caused in part because of the government’s timid response to the pandemic and the release of “ayuda” or stimulus package that caused the printing of more money.
Aggravating this increase in money supply is the sudden increase in demand due in part when the restrictions were lifted and the economy reopened. What further exacerbated the spike in prices was when Russia and Ukraine went into a full-blown conflict, further restricting movements of raw materials to Asia like wheat, gas, fertilizer, etc.
With so many internal and external factors happening, this long overdue inflationary environment finally found its way with the current downward spiral of our peso. This was expected as early as the last quarter of 2021 when I was pressed for an opinion on when rates would be adjusted and inflation would kick in. I warned that it was originally due to hit in 2021 but we should expect to hit land after the election, and so it did.
Beneficial to the real estate sector
How do investors use real estate as a hedge against inflation?
They capitalize on relatively cheap money by availing of developer-driven payment terms like lease-to-own schemes, no down payment or longer payment options, or banks’ low-interest mortgage rates (although banks have adjusted their rates already).
For rental markets, it is a question of timing. When the time to renew the lease contract happens, lessors will pass the rising costs to tenants by way of higher rental prices. Of course, before thinking of adjusting rental rates, your asset (office, retail, house or condo unit) must be superior in many respects.
Rising prices
There are several reasons why real estate prices also rise during periods of inflation.
First, it is an income-generating asset. Though real estate is a passive asset for many, it provides an excellent recurring income stream.
One reason property prices rise during inflationary times is that investors are on the prowl for assets that generate yields above and beyond the rate of inflation. The second reason why real estate prices tend to rise with inflation is because of the scarcity of real estate compared to a volatile currency that is highly regulated.
As the money supply grows due to greater amounts of money printing, real estate prices also rise. Similarly, interest rates also rise because our central bank would usually raise short-term interest rates in an effort to provide price stability and manage inflation.
The third reason is that investors tend to benefit from rising asset values. Residential prices historically increase over time, which is another reason why investors use property as a hedge against inflation.
To illustrate, purchases made 10 years ago of a typical mid-priced condominium in Makati or Cebu have gone up by over 80 percent, using a conservative annualized increase of 8 percent. For other premium developments in progressive areas like Makati, Bonifacio Global City, Cebu and Iloilo, real estate values have gone up at a much faster clip. Our research team forecasts that property prices in prime locations can rise annually by an average of 8 percent to 12 percent.
The fourth and final reason is the tendency for housing construction costs to increase. Inflation also causes the cost of building a vertical or horizontal project to increase due to rising wages and more expensive materials, supplies, and land costs.
In turn, developers pass on the cost of building a new project to buyers and investors, which is another reason why real estate prices have been rising.
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The article was originally published in Inquirer.NET and written by Prof. Enrique M. Soriano III.
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