Sunday, June 01, 2008

Florida Real Estate and Inflation

A constant motto in my conversations with potential customers is that inflation is a key factor in Real Estate investment.
My personal feelings have always been that inflation indexes and calculation have historically been somehow skewed and distorted and that they don't accurately reflect the reality of our currency devaluation throughout the last two decades.
A quick trip to supermarkets and gas stations and a quick look at your property taxes, property insurance bills, the price a new home, will quickly put in doubt the touted 2% or 2,5% annual inflation rates included in official economic data.

All signs are that we are heading into a period of high inflation, fed by enormous hikes in oil and food prices.

Real estate is a unique, valuable and tangible asset, which is not always the case with stock market shares, bonds, and other paper investments. World's population is constantly growing; the amount of available land and available natural resources is not. Unlike a dollar in the bank, real estate actual value will not shrink with inflation. Real estate will always be needed for residence, commercial, farming and industrial use.

My opinion has always been that, if we follow certain criteria and reasonable principles when acquiring real estate, it will always be, on the long term, the best investment we've ever made. In Florida, this is especially true, since we are one of the fastest growing states in the US, and we are due for a continued migration from of baby boomers from Northern states, Latin Americans, and Europeans.
The very high inventory of condos and homes available will be eventually absorbed – and faster than most of us realize. After all, a couple of years of low construction would be enough.

That's what, sooner than most believe, real estate is due for a strong comeback. And you better not be too late!
Here is an article on the subject that I read in a Realtors' publication.
I do not agree 100%, but it has an interesting twist on the subject.

Inflation: Winners and Losers

by Lawrence Yun, Chief Economist, NAR Research

An article from Real Estate Insights, a Web based publication of the National Association of Realtors.


Recent news on inflation is not good. In the first quarter of this year, the Consumer Price Index posted its highest level in years. A story in The Wall Street Journal last month carried the headline: "Inflation, Spanning Globe, is Set to Reach Decade High." We've all felt the effects in higher costs for food, energy, and other consumer goods.

Inflation is rather like a "stealth" tax: you have less purchasing power when it is high. However, if someone is paying higher prices, then someone on the other side must be receiving higher revenues. Many salary adjustments are based on the consumer price index, and entrepreneurs and businesses receive higher revenue. Mentally, though, people believe a rise in income is the reward for hard work, and feel the rise in consumer prices just eats into that hard-earned income. So, of course, inflation is awful.

But economists do not like inflation for other reasons. Large movements in prices distort price signals and lead to less efficient allocation of resources. Lower productivity growth holds back the country's economic potential and standard of living.

In the real estate sector, however, inflation produces distinct winners and losers. Let's take a look at both sides.

Homeowners Win

Rising inflation - other things being equal - raises people's income and their home prices. Usually, the increases would be nominal in terms of what you actually receive in paychecks and the listing price you would set to sell your home. Of course, we are not in normal times. Along with very high housing inventory, we have CPI inflation and income rising by 3 to 4 percent while home prices are falling in many local markets. But if inflation were to really get out of hand and rise by 10 percent, then the higher associated rise in income would help home prices recover in nominal terms - though not necessarily in real inflation adjusted terms.

Improving home prices from rising CPI inflation will in general protect homeowners' housing equity, and interestingly inflation can help reduce the mortgage burden. Fixed-rate mortgages are most prevalent in the marketplace. That means, the vast number of homeowners have fixed mortgage monthly payments. Higher income with fixed mortgage payments is a winning combination for homeowners.

Consider a typical U.S. homeowner in 1970 - when inflation was just picking up. She would have purchased a typical home for $23,000 (this is not a misprint). By 1980, the typical home price reached $62,200. Family income grew from $9,800 (also not a misprint) in 1970 to $21,000 by 1980.

So, while home prices and income grew, the monthly mortgage payment would have been fixed at $160 per month (assuming $23,000 mortgage at 7.5 percent interest rate). While the homeowner was undoubtedly angry about rising food , energy , and other prices back in the 1970s, she was not complaining about the mortgage payment.

Homebuyers Lose

As the homeowner was paying relatively low mortgage payments, banks and lenders must have been maddeningly frustrated. But what could the lenders do? Contracts are contracts and both parties agreed to the mortgage terms.

Not to be burned again, the lenders will rightly want to compensate for inflation before lending again. Mortgage rates - no surprise here - rose and rose. The average 30-year fixed mortgage rate rose from 7 percent in 1970 to 14 percent by 1980. It increased further, hitting a peak at 18.5 percent in October 1981. At such a rate, it would have taken 18 years to lower the principal balance by just 10 percent.

At such high interest rates, who would want to buy a home? Home sales, not surprisingly, fell big time. Home sales activity was essentially cut in half.

Yes, the current inflation rate is uncomfortable. But actually it is not very high. CPI has been rising at better than 4 percent over the past 12 months. That is well above the Fed's comfort zone of about 2.0 to 2.5 percent preferred inflation rate. The current economic weakness will likely help moderate inflation going forward. But the weak dollar, high commodity prices, and elevated gold prices all signal inflationary concerns. Once out of the box, inflation is hard to put back other than by sharply raising
interest rates purposely. That could cause a true economic recession, as happened in the early 1980s.

Fortunately, that is unlikely to occur. The Federal Reserve has already cut the Fed funds rate deeply. The 30-year mortgage rates have barely budged, however, given the lenders' concern over inflation. It is also quite possible for mortgage rates to rise even if the Fed cuts its Fed fund rate further and the lenders want to compensate for inflationary risk.

But I believe there are plenty of monetary stimuli already in the system to forestall any major concerns. As I have suggested before, what is really needed to lift the housing market is fiscal stimulus. The temporary homebuyer tax credit being debated in the House of Representative to purchase any homes (and not just foreclosed homes as is in the Senate proposal) is the appropriate medicine at this time - not only to the housing market, but for the broader economy. A housing recovery will help spur a true economic recovery. That will certainly help wash away any bad taste from our current inflation levels.

Henry B. Nathan is a Florida Realtor at United Realty Group Inc.
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