Real estate is an exceptional hedge against inflation. Generally, home prices appreciate on average at least as high as the published annual inflation rates like seen on the Consumer Price Index (CPI). For example, both annual rents and home prices nationwide increased approximately 18% and 19%, respectively, between late 2020 and 2021 as inflation trends continued to rapidly increase.
One of the fastest ways to cause uncontrolled inflation is when the US Treasury in affiliation with the Federal Reserve creates too many dollars too quickly. Inflation weakens the purchasing power of the dollar. Yet, inflation can benefit assets like real estate due to rising rents for rental properties and other factors.
In the entire history of the United States, we’ve never seen so many dollars created at such a swift pace. Back in March 2020, the total dollars in circulation, or M1 Money Supply, was $4 trillion. By October 2021, the M1 Money Supply had increased by a shocking $16 trillion to $20 trillion in total dollar circulation. In January 2022, the total US Debt surpassed $30 trillion for the first time ever. As a result, storing cash under your mattress may not make as much sense these days because the purchasing power continues to plummet.
Skyrocketing Home Inflation
Real estate investors, on the other hand, are experiencing massive wealth gains thanks to hyperinflation by buying and holding their properties and watching their home prices increase 10%, 20%, 30%, or 40%+ per year, depending upon their locations. While the dollars in their pockets may buy fewer and smaller cups of coffee or tea these days, their real estate gains are helping offset the declining purchasing power of the dollar.
Lumber prices nearly tripled in price between August and December 2021, according to the National Association of Home Builders (NAHB). As a result, these staggering lumber price jumps increased the sales price of an average new single-family home by more than $18,600.
While inflation has been bad for new home buyers and tenants, it’s been exceptional for homeowners and rental property owners. Between October 2020 and October 2021, the average home in California rose in value $119,000 as per CoreLogic. Now, please imagine owning 10 rental properties in California or elsewhere and seeing your net worth increase by almost $1.2 million in just one year.
Homes in Orange County, California were reported as increasing at a rate of $11.27 per hour between February 2020 and October 2021. Isn’t it more fun to let your money work hard for you than to work hard for someone else and collect income near the minimum wage rate?
Rising 30-Year Fixed Rates
Historically, almost all boom and bust housing cycles are tied to the directions of 30-year fixed mortgage rates and the corresponding 10-year Treasury yields. Over the past 50 years, Freddie Mac published data which noted that the average spread between the 10-year Treasury yield and 30-year fixed mortgage rates was 1.7%. To simplify, please add 1.7% to the published daily 10-year Treasury yield to get an approximate idea of the latest 30-year fixed mortgage rate trends (ex: 1.8% yield for 10-year Treasury + 1.7% average spread = 3.5% 30-year fixed mortgage rate).
Because the 10-year Treasury yield reached all-time record lows in recent years, 30-year fixed mortgage rates also reached all-time record lows while boosting home prices to all-time record highs in most regions nationally. Had interest rates reached record highs over the past few years, home prices would’ve likely fallen at near record loss percentage rates instead.
In January 2022, Federal Reserve Chairman Jerome Powell talked about possibly raising rates three or four times in 2022, another three or more times in 2023, and up to a few more times in 2024. If so, will it be more common to see mortgage rates closer to 5%, 6%, 7%, 8%, or 10%+ like in decades past?
Let’s take a quick look below at the average 30-year fixed mortgage rate over the years.
Many younger real estate investors probably didn’t experience a housing cycle when 30-year fixed mortgage rates were closer to historic averages near 7%. If inflation rates continue to rise at a rampant pace, the Federal Reserve could actually increase rates faster than what they are publicly stating.
Energy Costs – The Root of Inflation Trends
Rising energy costs are usually the root cause of inflation trends. Due to the fact that the US dollar is truly a petrodollar that’s linked to an “oil for dollars” exchange with Saudi Arabia and several other nations dating back to the 1970s, the declining purchasing power of the dollar is usually inverse to rising energy and inflation costs like visualized as a seesaw. Conversely, falling inflation rate trends are typically seen when energy costs are lower and you can buy more goods and services with a stronger dollar.
The Personal Consumption Expenditure (PCE), which is the Federal Reserve's favorite inflation indicator, remained near 30-year highs in the 4th quarter of 2021 and was last seen this high back in 1991. The Fed usually pushes short-term interest rates higher when energy costs spike too high. For comparison purposes to the 1991 inflation era, the 10-year Treasury yield was above 8% and the average 30-year fixed mortgage rate was 9.25% in 1991.
Between March 2020 when the global pandemic designation began and January 2022, the core US oil index named West Texas Intermediate (WTI) crude fluctuated between -$37 (yes, negative $37) and almost $90 per oil barrel in more recent times. You’ve probably noticed gasoline, food, clothing, utilities, and restaurant prices rising dramatically right alongside the higher energy costs.
In December 2021, published annual inflation rates reached 40 year highs. Back when published inflation rates were this high in the early 1980s, the Federal Reserve pushed the US Prime Rate up to a whopping 21.5% rate while the 30-year fixed mortgage rate rose to the 14% to 16%+ rate range. Could you imagine your mortgage rate increasing from 3% or 4% up to 16%? If so, how would it impact your cash flow potential for rental properties or your ability to afford the purchase of a new owner-occupied home?
The Federal Reserve’s #1 weapon of choice to combat or quash rising inflation trends is usually the process of increasing interest rates. Sometimes, the Federal Reserve overreacts as seen with 17 federal fund rate hikes from 1% to 5.25% between 2004 and 2006 prior to bursting the stock and housing market bubbles in 2007, 2008, and beyond.
How quickly will the 10-year Treasury yield and corresponding 30-year fixed mortgage rates rise in the near future? If so, are you locked into a long-term fully amortizing 30-year fixed mortgage or a 7-year, 10-year, or 30-year interest-only payment with much lower monthly payment options so that you can continue to boost your net worth with escalating real estate gains?