Inflation and Rental Income

One of the many advantages of real estate is how it performs in times of inflation. This article will explain the impact of inflation for properties financed with a fixed rate loan.

Example:

  • Purchase price: $180,000
  • Financing: 20% down, 30 year term, 5% fixed rate
  • Property tax: 0.55%
  • Management: 8% of collected rent
  • Landlord insurance: $400/Yr
  • Rent: $1,150/Mo.

Below is a table showing the example recurring cost elements and what percentage of total cost each element represents.

Cost Component Monthly Total Cost %
Debt Service 773 79%
Management 92 9%
Property Tax 83 8%
Insurance 33 3%
Total Recurring 981 100%

As you can see, the largest cost component is debt service, which remains constant. Fixed rate long-term financing is one of the biggest advantages of residential real estate.

Inflation Effects

The following table shows the relative effects of 10 years of inflation on income and recurring costs at various inflation rates.

Inflation Effect Current 3% 5% 7% 10%
Rent 1,150 1,546 1,873 2,262 2,983
Debt service -773 -773 -773 -773 -773
Management -92 -124 -150 -181 -239
Property Tax -83 -111 -134 -162 -214
Insurance -33 -34 -36 -39 -42
Cash Flow 169 504 780 1107 1715

Historically, rental rates rise with inflation. Debt service, however, is fixed, which increases cash flow. The table below shows how cash flow increases with inflation at various rates.

Recurring Cost Current 3% 5% 7% 10%
Debt service 79% 74% 71% 67% 61%
Management 9% 12% 14% 16% 19%
Property Tax 8% 11% 12% 14% 17%
Insurance 3% 3% 3% 3% 3%

Inflation has additional benefits to real estate investments:

  • You can pay off the debt in the future with inflated dollars because debt is fixed.
  • Interest rates rise when inflation occurs. As interest rates rise, fewer people can afford homes and are forced to rent. The increased demand for rental properties drives rental rates and values of homes up.

Summary

Very few investments benefit from inflation like real estate. The main reasons real estate handles inflation so well are:

  • Rents have historically tracked inflation while your major costs are fixed.
  • As inflation increases, fewer people can qualify for loans or afford payments thus rental demand increases which further drives up rents.
  • Incomes increase as the value of the dollar decreases. The effect is that you will be paying off your mortgage with inflated dollars.