How Does Deflation Affect Real Estate

Is deflation a real threat? How will it affect the property market and what should an investor do if deflation does brew its ugly head? These are tough questions so let us examine each of these issues.

Why are economists talking about deflation when so much money is being printed by governments all over the world in order to revive the world economy? We should be worrying about hyper inflation instead. Is it not a case of too much money chasing too few goods that should increase inflationary pressure? One the face of it appears that inflation is like to happen but the situation is much more complex when you examine the underlying economic data.

Most of the money that the governments are pumping into the system is going to the banks with the hope to encourage them to lend and increase their profits so that they survive. Unfortunately, little of this money has entered the economic mainstream and reached the end users. Instead of lending the money, the banks are increasing their reserves or buying other banks to boost their balance sheets.

On the other hand consumer and businesses confidence is so low that they are borrowing less. They are on the other hand trying to bring down their debts. According to the Forbes magazine households will reduce their total debts by $200 billion and banks and businesses by $2.3 trillion this year . The promise that increased loans from the banks will result in boosting the faltering economy has not been fulfilled.

The burst of the housing bubble has created wealth effect in reverse. People can no longer use their homes equity as ATMs by taking out lines of credit or refinances their homes to fuel consumption. The reduction in equity is destroying wealth at a much faster rate than any money supply that governments are pumping into the economy. This is creating a very powerful deflationary pressure.

The combination of reduced wealth and lower incomes raises the possibility of individuals and companies increasing savings to pay down debt rather than spend money on consumption to boost the economy. This is evidenced by the fact that retail is suffering its worst decline in decades and are reducing their inventories to stay afloat.

Falling real estate prices, reduced spending by consumers and high unemployment rate will result in an inward spiral of deflation.

It must however be remembered that long-term accumulation of debts and deficits can reignite inflation. In any event, inflation is easier to control than deflation. Governments can control inflation by raising interest rates and this can be done very quickly. However counter measures against deflation are more difficult. You can not cut interest rates below zero in order to kick start the economy. Japan is a living example were stagflation has persisted since early nineties in spite on near zero interest rates.

Deflation can result in property prices staying stagnant or even going down. Financial pressure on businesses and individual can result in increase in vacancy rates and will eventually result into reduced rentals. This is definitely not good news to property investors.

The silver lining for real estate investors is that mortgage rates will come down substantially and will result in cash flow positive properties even though the rents may decrease marginally. There will be erosion of capital wealth if you are holding onto a large portfolio. On the other hand it will be cheaper to buy properties for positive cash flow.

By leveraging your finance properly when buying real estate you will be able to generate very high cash on cash returns at a time when return from stocks, bond and deposits will be near zero or negative. The one thing you have to focus on is to invest only in prime real estate or vacancy rates will eat into your profits.

If you believe deflation is around the corner then sell your poorly performing assets in secondary locations where renting can be an issue. You may suffer notional erosion in value of your properties but it will be easier to sustain them because of lower cost of borrowings. Keep your mortgage rate on floating to take advantage of the lower rates in future.

Inflation is a much lesser threat to property investors than deflation. Deflation also has the nasty habit of persisting for years on end. The economic situation is so fluid at present that it is a toss between inflation or deflation. If you are a real estate investor keep your ears to the ground. You can take advantage of any market situation if you are prepared for it and willing to take action.

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