Inflation in Germany in October was around 10% year-on-year. In the USA, it fell to around 8%, following a high of 9.1% in June. And if you look at individual commodity stocks, it looks like the high inflation rates won’t change anytime soon.
The question for us investors now is: How to act? What can be done to ensure that one’s assets are not eaten up by inflation?
Now I hear more than ever that one should invest in real estate. But is real estate a good solution in times of high inflation in germany?
This is exactly the question I would like to explore in this article.
What is inflation, anyway?
Inflation is the increase in the general price level of goods and services. Inflation in Germany reduces the purchasing power of money – that is, more money is needed to buy a particular item.
Inflation in Germany is calculated by looking at price changes for a particular group of goods and services between two points in time.
There is a defined basket of goods for calculating the official inflation rate in Germany. The price increase of this basket of goods is recorded in the consumer price index – the official inflation rate that is always referred to.
In Germany, the observed “basket” (Warenkorb) is an intersection of all the products and services on which the average German household spends money.
Such goods are for example
- food products,
- cloths,
- equipment for home and garden,
- vehicle purchase or repairs
- internet and telephone charges
- kindergarten or care facilities services
- bank fees, insurances.
If you would like to see the entire shopping basket, you can download it from the website of the Federal Statistical Office (Statistisches Bundesamt).
However, since every household manages differently and has different expenses, the personal inflation rate may deviate from the average. Therefore, depending on which services a person demands, his or her personal inflation rate will change.
If you are already tracking (and categorizing) all your expenses ,as I suggest in this blog post, then you can easily calculate how much your lifestyle is being affected by the inflation in Germany.
This calculator from the Federal Statistical Office can be used to calculate the personal inflation rate.
How does inflation affect real estate prices?
The impact of high inflation rates on real estate prices depends on where this inflation comes from.
One explanation for the current high inflation rates lies in the massive expansion of the money supply in recent years. In order to cope with various crises, the money supply has been massively expanded. In contrast, however, the quantity of housing has remained relatively constant.
Thus, the available money supply has increased more than the available amount of housing. Inflation in the prices of all tangible assets, and especially inflation in the prices of real estate, has been the result.
Specifically, between 2015 and 2020, the money supply in Germany expanded by around 30%. Put simply, there has been 30% more money since 2015.
In parallel, real estate prices in Germany have risen by 45% on average.
Residential property price index
© Deutsche Bundesbank Status as of: 21.02.2022
Real estate has thus risen in price even more than the money supply evaluation, and real estate was thus a good inflation hedge. But does this also still apply today?
Why does real estate protect well against inflation in Germany?
As seen in recent years, the price of real estate increases with inflation in Germany.
So, if the money supply continues to expand in the future and the supply of available real estate nevertheless remains the same, real estate will rise in price accordingly to compensate for the additional money supply created.
In the long run, however, this relationship applies to any tangible asset. For example, the price of an ounce of gold also increased by about 50% from 2015 to 2020.
However, real estate has other special features that other tangible assets do not have and that make real estate investment very appealing.
The loan for a property is devalued by inflation in Germany
As a rule, real estate as an investment is financed by a loan. And where with a high inflation savers are expropriated by the inflation in Germany, the load of the debts is reduced on the other side.
Concretely: If you take out a loan (e.g. for a property), you have to pay back this loan exactly in the amount taken out over the next years.
Important here: One must repay only the nominal loan amount! If the value of the money sinks by inflation, thus also the value of the debts sinks.
Example: With an inflation of 5% the value of money halves every 14 years. Even without repaying a loan, the debt is halved by inflation alone.
Therefore, if you buy real estate with other people’s money, inflation in Germany works for you and no longer against you.
So everything is fine, isn’t it?
Why is real estate not an optimal protection against inflation after all?
The main reason why real estate is not an optimal protection against inflation in Germany is that the costs of real estate usually increase more than the income in an inflation.
Costs in real estate also increase
As with any other business, when inflation is high, costs rise in real estate. As with companies, the question is then how much to pass on the increased costs to the end consumer.
Since the rental market in Germany is heavily regulated, for example by the “Mietpreisbremse”, a landlord can not usually pass on the inflation-related cost increases 1:1 to its customers in the form of rising rents.
This can also be seen very clearly in the following chart. After 2016, rents in Germany rose at a similar rate to the general inflation rate (approx. 6%). However, construction costs for real estate have risen by over 20% in the same period till 2021.
This mean that while the value of the property increases together with the inflation, the rent doesn’t. The return from the rent won’t dim the effect of the inflation on you, but
Conclusion
Even real estate is not a panacea in times of high inflation rates. Nevertheless, they offer many advantages for asset protection.
As tangible assets, they increase in value in the event of inflation in Germany, and the credit leverage makes inflation work for the investor.
However, as with any business, the margin on real estate deteriorates in times of high inflation and the free cash flow from the investment shrinks, because you cannot pass on the increased prices in full, but have to bear them to a certain extent yourself.
For me personally, however, the advantage with the credit leverage weighs so strongly that, in sum, real estate is an interesting asset class for me in times of high inflation in Germany.
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