The key to comprehending economics and finance is to understand prices. These do not exist in a vacuum but touch upon supply and demand; interest rates; investment portfolios; and even employment rates. Lowered prices often reflect declining demand for products and services. Rising prices can conversely indicate stronger demand, but not always. Sometimes, rapidly increasing costs result from inflation, i.e., when the purchasing power of money weakens due to an expansion in the overall money supply. What went for $3.75 a year ago now is sold for $5.06, for example. The product did not change in substance or amount; only the dollar shrank.
How Does Inflation Work?
Economists are in general -- though not perfect -- in agreement about the conditions that give rise to inflation. The broad view is that inflation happens when the growth in money supply overtakes overall economic growth. Following this, currency sheds its value, and therefore is able to buy fewer and fewer things unless augmented by more money. This is true on the supply side, too. A logging company pays more to acquire and maintain equipment and passes that extra cost on to the lumber yard. The retailer pays more for the wood so likewise marks up the price for the consumer in order to make a profit. In turn, the consumers need more income, so they agitate for pay raises at work. Consequently, the employer must charge more for its products or services, and the cycle continues.
How Does Inflation Affect Real Estate
Almost immediately, we can see how this inflationary rhythm impacts new home sales. Builders are paying more for materials and labor, driving up wholesale prices. When it costs more to build a home, it will become pricier to buy that dwelling because -- after all the extra expense -- the builder needs to get paid too. Yet swelling house prices go far beyond new construction and that is good news for the owners of existing homes. Just as inflation drives up the value of lumber, light bulbs, potatoes, chicken and women's shoes, it boosts home values in the same way. For instance, and for simplicity, if there are 30 identical houses and $600 in circulation, each property would be priced at $20. Double that money supply to $1,200 and the price per house jumps to $40. Of course, myriad factors are involved in home values, but inflation must be accounted for.
Who Does Inflation Help? Hurt?
As is evident, a seller can take advantage of inflation with a high sales price, especially if the seller is downsizing to a less expensive residence. Proceeds from the sale are that much higher. It follows that the realtor commission will also be more substantial. The flip side is that the transaction takes more out of the buyer's pocket than if inflation were not a factor. This is especially true when housing inventories are low -- a perfect illustration of money supply outpacing economic growth.
What about investors, who both buy and sell? Mainstream wholesalers are often most interested in distressed properties so it is doubtful that inflation will significantly make purchases cost prohibitive. However, inflation takes a toll on the price of renovations, a variable that will very well influence the bottom line. At the same time, as property values jump, landlords can raise their rents since the cost of maintenance will go up with inflation. Not to be forgotten are property taxes, which will also rise in tandem with values. So, investors have opportunities to prosper under inflation as long as inputs are minimized.