How does rising inflation affect the housing market
So, should you buy a house now?
Short answer:
No.
Long answer:
One day, I read a book called The Signal and The Noise by Nate Silver [1]. On page 28 in the PDF version, there is a figure of the Case-Shiller Housing Index, an economic indicator measuring the change in the value of U.S. single-family homes (Figure 1). In 1890, if you had bought a home for 200?000 USD, for example, 100 years later, in 1990, you would have sold the house for the same price. From the perspective of history, the home's value would have just retained its value adjusted by inflation. In other words, the real inflation-adjusted annualized return has been less than 1 % over time.
Figure 1. Case-Shiller Housing Price Index as a function of time in the U.S.
Suddenly, in the '90s, housing prices increased substantially. The following graph (Figure 2) illustrates the U.S.'s Cape & Shiller Housing Price Index from 2000 [2]. If we combine Figure 1, we can observe that we would buy a property nearly three times the inflation-adjusted value it would have cost in 1890 – 1997. The index has remained near 100, but now the index since 1997 has increased to 310.
Figure 2. Cape & Shiller Housing Index in the years 2000 – 2020 in the U.S.
What concerns me is that in the U.S., the home prices vs. median income of the citizen have risen substantially from 2000 to 2022. Figure 3 represents the ratio of home prices compared to the median income. We have not been this high for a long time. The 2008 housing crisis is also labeled. Nevertheless, the average income of the citizen has not risen by the same magnitude as income [3].
Figure 3. Housing prices vs. average income ratio in the U.S. since 1947.
You may wonder, what is the root cause of increased housing prices? There is no denying that, for example, interest rates, regulation, building costs, material costs, taxing, subsidiaries, and popularity to work from hope play a significant role in adjusting the prices. Simply, it is an increase in demand. Nowadays, I have recognized some beliefs that we generally think about the real estate market:
Since we live in a high inflation economic environment relative to previous decades, I want to talk about how the rising inflation will affect housing prices in the future. And why we have had a rapid rise in housing prices from the perspective of interest rates, and why you may re-evaluate previous statements.
In this article, I do not want to go into detail about what has caused the current environment, for example, management by the central banks and the conflict between Russia and Ukraine. However, these are other topics to discuss.
What is inflation?
Inflation is a term that measures how much goods or services cost related to previous years. Generally, we want the average inflation over the years to remain at 2 %. In simple terms, the apple bought from the local supermarket at 1.00 USD would cost 1.02 USD the next year and 10.404 USD the year after the following year, and so on. So after ten years, your apple would cost 1.219 USD.
Another great way to understand inflation is to ask yourself: Would you buy an apple this year if the apple is more expensive in the next year? Of course, there is a higher probability that you would buy the apple this year (The apple would rot within the year, but that was not the moral of the story). By inflation, consumers are willing to pay for goods or services now rather than next year. Inflation keeps the economy running.
If the inflation is negative, say –2%, why would you buy an apple this year? If you know for sure that the apple would cost 0.98 USD in the next year? Thus, there is a higher probability that you would save money because everything will be cheaper in the future. Negative inflation is known as deflation.
Who adjusts the inflation?
In the E.U., inflation is controlled by The European Central Bank (ECB). In contrast, in the U.S., inflation is managed by The Federal Reserve (FED). Controlling inflation is the primary mission of each of these authorities. If inflation deviates too much from 2 %, these authorities apply monetary policies to control the supply and demand of the currencies.
One example of monetary policy is to control of interest rates. The interest rate is the rate at which banks can borrow money from the central bank. If the central bank raises the interest rates, your local bank must offer you at least the same interest.
If inflation rises, the central banks must act to raise interest rates. Increase in interest rates will eventually slow down the economy because borrowing is not as cheap as previously. Lower interest rates encourage borrowing and investing, but higher interest rates reduce willingness to borrow money. From the macroeconomic perspective, rising interest indicates that the residual part of your salary is lower. Therefore you cannot spend your money as much as you would with low-interest rates.
Understanding the effect of rising interest rates
Consider a simplistic example of you buying a house for 250?000 EUR with a loan of 200?000 EUR. The central bank's interest rate increased from 1 % to 3.5 % in two years. Your local bank takes a risk additional risk of 0.5 %.
Example 1: 1 %
The yearly amount of interest paid to the bank is (1 % + 0.5 %) * 200?000 EUR = 3 000 EUR.
Example 2: 3.5 %
The yearly amount of interest paid to the bank is (3,5 % + 0,5 %) * 200?000 EUR = 8?000 EUR.
Thus, if the interest rate rises 3,5 %, you must pay the bank an extra 5 000 EUR per year. In addition to the interest, you must shorten your actual loan each month. An additional 5000 EUR/year is a significant expense for most people. However, we can approach this subject by the question: How much you are willing to borrow so that the yearly interest paid is 3000 EUR maximum. The calculation is straightforward:
3 000 EUR / 4 % = 75?000 EUR.
If the interest rates rise, you want to borrow significantly less. In this example, the difference is:
200?000 EUR – 75?000 EUR = 125?000 EUR.
The real question is: How much are borrowers willing to sacrifice their living standards as the interest rates rise? With this example, the borrower did not want to sacrifice anything. However, in reality, every borrower adjusts their living standard so they can live with the expenses if they decide to buy a property.
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History of inflation and interest rates
So, why did I take an example of interest rates of central banks going to 3.5 %? If we try to understand what could happen in the future, we must understand the history. The beauty of inspecting accounts is that, by the nature of human beings, we tend to make the same mistakes repeatedly in the financial markets.
I wanted to show three demographics from the U.S. and E.U. areas. In Figure 4, Inflation and interest rates have gone hand in hand all these years [4][5]. However, since the Corona epidemic, we have observed a significant rise in inflation. On the other hand, interest rates and inflation have been declining since 1981. However, we saw these inflation values in 1981 when the central bank's interest rate was 13 %.
Figure 4. U.S. interest rates and inflation as a function of time since 1972. Brown = US inflation, and Blue = US interest rates.
Next, we have an interest rate and inflation as a function of time since 1992 in the E.U. The same trend happens. Inflation peaked at a significantly high number in 2022. Moreover, U.S. and E.U. areas have behaved similarly with the interest rates. [6][7] As the USD acts as a world reserve currency, we must pay attention to these geographic areas since the USD can measure every good and service.
Figure 5. E.U. interest rates and inflation as a function of time since 1992. Blue = EU inflation rate, Green = US inflation rate, Brown = EU interest rate.
Furthermore, if we inspect the U.S. inflation rate from 1915 (Figure 6), we can observe that inflation has tended to peak at high numbers, but they have rapidly decreased due to increased interest rates. We have seen high inflation in 1916 – 1020, 1942, 1947, 1952, 1974, and 1980. These years have exceeded the current inflation rate.
Figure 6. U.S. Inflation rate since 1915 in the U.S.
To conclude these demographics, the inflation in both regions is relatively high compared to the previous years. As a result, the interest rates of both geographic areas follow each other, and there is substantial pressure to raise interest rates to decrease rising inflation.
Interestingly, these graphs show that since the financial crisis of 2008, we have approached a unique economic environment where real interest rates have been near 0 %. This means that nominal interest rates have been under 0 %. In simple terms, negative nominal interest rates mean you are paid to take the loan. This environment has led borrowers to borrow a lot with the assumption that the interest rates do not rise in the future.
If we think of this theoretically, we can interpret the 0 % real interest rates environment from two perspectives:
However, expecting that interest rates do not rise in 10 years from the 0 % environment, wouldn't you borrow an infinite amount of money and leverage that money if you are confident that other investing instruments yield more than inflation-adjusted 0 % in a year. Yes, you would, because not borrowing money is just pure stupidity in this theoretical framework.
And that is the problem. 0 % interest rate environment leads to much borrowing, but how do the borrowers handle the increasing expenses in the future if the inflation rises?
What happens to home prices if the central banks raises interest rates?
A few things happen:
What will happen to you if this scenario occurs?
Consider a simple example: you borrowed 200?000 EUR for a property before the interests rose. The value of your property was 250?000 EUR in total since you have consumed 50?000 EUR of your own money for the property.
The selloff starts. The borrowers cut their living standards so that the housing market declines 37,5 %. And yes, this could easily be the case since if borrowers do not want to miss their living standards, the decline would be more. As we calculated in the previous example, how the interest rose from 1 % to 3,5 %, the borrowers wanted to borrow 125?000 EUR less for the property without cutting their living standards.
So, your apartment is worth 175 000 EUR in your area after two years. Due to rising interest rates, you conclude that you cannot afford to live in your apartment anymore and must sell your property. The loss of your net worth is:
250?000 EUR – 175?000 EUR = 75?000 EUR.
Expect that you will cover your loan with this 175?000 EUR for your bank. Since the original loan was 200?000 EUR, you must pay the interest for 25?000 EUR for your bank:
200?000 EUR – 175?000 EUR = 25?000 EUR.
In conclusion, you have lost 75?000 EUR in your net worth, and you must pay interest to the bank for 25?000 EUR. The scenario sounds horrible.
So, what should you think about the future?
The purpose of this article was to give perspective on what is happening from the perspective of rising inflation and interest rate to the housing prices. Furthermore, the object was to describe historical phenomena over a long time.
We live in an environment where rising interest rates may be crucial for most countries and companies. Central banks can not raise interest rapidly because the government and corporate debts are relatively very high, and thus the countries and companies may default on paying claims. In contrast, increasing the money supply raises inflation. The situation is challenging.
If you asked me what you should do, I would say I do not know. Because most predictions will eventually fail, and therefore, as a disclaimer, this article is not financial advice. Furthermore, I am not a financial expert, and you should do your research always.
Your local bank probably offers fixed-rate loans and other possibilities to cover your fear, but I want to point out that the bank does business with your money.
I believe that inflation will decrease to 2 % in the long term, but how we get there is the central bank's task to solve. I continue to watch the situation closely, especially how the average income of the citizen will behave in the future. I predict we will see a decline in housing prices in U.S. and E.U., but the magnitude is unknown. It could be that this peak in inflation is temporary and the interest rates remain low in the future as well and central banks print more money to adjust the economy. For me, rising interest may create an excellent opportunity to buy my first house.
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