There is a connection between inflation and real estate, with some suggesting that the real estate industry serves as a hedge against inflation, particularly concerning rental income. Rental income growth and inflation are directly affected by factors such as market supply and demand, which determine a landlord’s ability to raise rents. In times like these, investors should assess both income and total return from real property investments, taking into account property appreciation or depreciation. Read the full article:
The Merriam-Webster Dictionary defines the term inflation in the following manner: “a continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services”. If that left you scratching your head, then you’re not alone.
Let’s try again. Inflation is “the gradual loss of purchasing power, reflected in a broad rise in prices for goods and services”. Inflation, in a nutshell, is the persistent rate at which the cost of goods and services rises over a period of time. To break it down further, when one unit of currency, be it a Canadian dollar, US dollar, yen, pound, or rupee, doesn’t go as far as it once did, a consumer can purchase less for that unit of currency than they once could.
How is Inflation Determined?
The goods and services in the Consumer Price Index (often referred to as CPI) basket are divided into eight major segments: Shelter, Food; Household Operations, Clothing and Footwear, Furnishings, and Equipment; Health and Personal Care; Transportation; Education and Reading; Recreation, Alcoholic Beverages, Tobacco Products, and Recreational Cannabis (this last segment was expanded recently with the decriminalization of marijuana in Canada).
Do We Have a Type?
Although some economists feel that there are more types of inflation, for the most part, they all seem to agree on the following three primary classifications: Cost-push inflation, built-in inflation, and demand-pull inflation.
Demand-pull Inflation describes the relationship between demand, or the collective consumer want for a product or service, and its price. This notion of inflation relies on the principle of scarcity. The more limited the supply or rarer the item, the higher the likelihood that you can generally get people to pay more for it. This can be summed up as “too many dollars chasing too few goods.”
One only needs to turn to online auction sites like eBay to see this form of inflation in practice.
Cost-push inflation is a by-product of demand-pull inflation going well. When the cost of raw materials to build a product increases for a company or business, the business in turn must raise the price the end-consumer pays, regardless of demand.
When the price of coffee beans keeps going up, for example, eventually your favourite Canadian coffeehouse will need to charge more for your morning cup of joe.
As demand-pull inflation and cost-push inflation mount, employees may turn to their place of employment to ask for a raise. If employers don’t keep their wages in line with the market, competitively speaking, they could lose employees and, in turn, find themselves in a labour shortage position.
If an enterprise increases its staff’s salaries or wages and tries to maintain the existing profit margins by downloading those costs to consumers by raising prices, that’s when the phenomenon of built-in inflation occurs.
Now, if you learn about your favourite coffeehouse raising prices due to the climbing cost of coffee beans, you’re a victim of cost-push inflation.
If you’re still purchasing your double-double each morning even though the price is uncomfortably high, you are an active participant in demand-pull inflation. Meaning the market determines the price, and we, the consumers, are the market.
Inflation and the Great White North
Those who say that the global COVID-19 pandemic was the match that lit the largest inflationary flame in Canadian history are wrong, or at the very least are oversimplifying.
Although comparatively speaking, the 8.1% high that we Canucks saw in June 2022 reached levels not seen for nearly four decades before, our great nation has certainly seen higher inflation rates.
According to TD Bank, Canadian inflation rates soared. “Canadian gasoline prices ended up rising by 45.5% in 1981, which pushed the Canadian CPI to an all-time high of 12.9%”.
As young as our nation is, we can find an even higher inflation rate if we go back into the archives.
The inflation rate in Canada reached an all-time high of 21.60 percent in June 1920. The cause of the skyrocketing post-World War I inflation was the scarcity of resources and the subsequent high demand that it caused as a result.
The Not-So-Missing Link
There is a link between inflation and real estate. In fact, some claim that real estate is a good hedge against inflation. There is some statistical proof in that proverbial pudding, at least as related to rental income.
The strength of the intersection of inflation and growth is influenced by other variables, such as supply and demand in the market.
It is this balance that will influence whether a landlord can increase the rental amount on their units. When demand-pull causes costs to rise, the obvious correlation is that real estate demand and subsequent rents will rise, as well.
Conversely, when inflation is cost-push in nature, the prices rise without a corresponding increase in demand. The impact on investors and landlords is that there is no appetite in the market for increased per-unit rental amounts. Ultimately, the long-term real estate trend seems to imply that property values will keep pace with inflation.
Investors with real property in their portfolio ought to consider not just the income but the total return that comes as a result of the income and the appreciation or depreciation in the asset’s value. The relationship between the performance of a property and a market’s rate of inflation depends on the state of that market as well as the nature of the inflation, itself.
The key takeaway is that the single largest driver of the performance of a property lies in the occupancy figures, which come as a result of a state’s economic fortitude. In broad strokes, investment properties’ returns and a nation’s gross domestic product growth are positively correlated, but on a much larger scale than the relationship between property performance and a state’s rate of inflation.
There is credence to the belief that the COVID-19 pandemic was the match that lit the inflationary flame. As people got sick and couldn’t work, that affected the supply chain, which in turn affected prices for limited supplies. We have seen firsthand its impact on the Canadian economy. However, if the long-term historical economic trends are to be believed, and a little faith is given to the navigational ability of the Bank of Canada, then, as the saying goes, ‘this, too, shall pass’.