Interest rates are at the highest levels in recent history, and many investors wonder if the Federal Reserve will raise rates again. Concerns persist about whether inflation can be kept in check and if the United States economy is on track to avoid a recession.
Understanding the influence of the central bank on inflation and interest rates can offer insights into where the market may be headed. This will play a significant role in adjusting real estate investment strategies for strong returns.
What's Going on in the Market Right Now
In March 2022, after having endured several months of elevated inflation that was initially deemed "transitory,” the Federal Reserve embarked on a campaign to raise interest rates and cool inflation. The campaign was initially stalled due to the Russian invasion of Ukraine, disruptions to the supply chain, and other lingering supply chain challenges from the global pandemic. However, the slow start accelerated into what is now the fastest rate hike campaign in modern history.
Banks have tightened lending policies and incentivized deposits to bolster their capital base and mitigate stress. This caused high-yield savings accounts to surge and increased the cost of borrowing with higher interest rates on home and car loans. As inflation challenged the value of some assets, institutions, including Silicon Valley Bank, experienced catastrophic losses.
Despite historic pressure from every direction, the broader economy and several industries have demonstrated greater resilience than many expected, with unemployment still low and labor participation at its highest point in more than 10 years. There are still plenty of places to find a silver lining in real estate for investors willing to look.
Opportunities for Real Estate Amid Inflation
- Property valuation grows, making it a strong hedge against inflation.
- Existing fixed-rate debt associated with property assets is devalued.
- Rent historically has increased amid rising inflation, benefiting owners of income-generating properties, such as multifamily housing.
- Commercial properties are closely tied to consumer prices and can see strong growth in response to a rising rate.
- The rate of new development slows down, reducing competition with existing property inventory.
Challenges for Real Estate Amid Inflation
- New development becomes more expensive as the cost of goods and labor increases.
- Higher interest rates make new mortgages less affordable.
- To incentivize property sales over the high cost of debt, motivated sellers will reduce list prices.
Causes of Inflation
The perceived value of things—including real estate—changes when there’s more or less demand, scarcity, or a greater opportunity cost. Inflation is the price the market sets, and when prices continuously go up, the dollar doesn’t stretch as far.
The Consumer Price Index indicates the average change over time in how much consumers pay for goods and services. Shifts in supply and demand, cost of materials, or changes in purchasing behavior, such as a willingness or reluctance to spend money, are primary drivers of inflation.
High inflationary pressure is a sign to carefully consider financial planning. The cost to borrow money or interest rates will increase, the value of purchasing power will decrease, and the performance of assets will vary. Equities and bonds are unlikely to deliver strong returns as sustained inflation can erode their value. Commodities and essential goods historically have been able to perform well. Depending on the asset class, real estate values can be either more resilient or susceptible to higher interest rates.
Why Interest Rates Are High
Interest rates and inflation often rise and fall together as the Federal Reserve seeks to maintain a healthy economy. When inflation rises, the central bank works to stabilize prices. The key resource leveraged to manage inflation is the federal funds rate, the heart of the relationship between interest rates and inflation.
The Federal Reserve sets a target rate for banks to borrow and lend with one another. Each bank needs to maintain capital reserve requirements to ensure deposit withdrawals are guaranteed. Any funds exceeding the minimum reserve can be lent to banks with shortfalls, and balances gain interest at the federal funds rate.
As the cost of borrowing between banks becomes more expensive, it effectively restricts the available supply of money. Banking stress increases, and interest rates are raised to ensure lending remains profitable with less risk. Each action triggers a reaction, and the impact is traded from one element of the financial system to another.
The steady climb of prices has elevated wages and raises concerns about whether adjusting the federal funds rate will be enough to prevent recession or if it has sustained inflation expectations. Interest rates are at a 20-year high, but there are signs inflation may be cooling.
Where Investors Need to Invest
For risk management in a reactive economy, assets such as low debt, value stocks, real estate, and commodities will be well positioned. To further limit the risk of inflation, diversifying investments with non-correlated assets will provide greater stability.
Well-diversified assets offer the investor greater protection against market fluctuations. This can be highly beneficial and, in the case of hard money, increases growth potential because the best way to ensure positive long-term returns is to avoid losses. In a high-interest economy, as banks tighten lending policies and restrict available financing, hard money lending—which provides short-term loans secured with real estate assets as collateral—fills a larger role.
When underwritten and managed conservatively, they are well secured, comparatively stable, and the shorter term minimizes duration risk. The key risk is if collateral falls below the principal balance. However, as demand for financing increases in an inflationary climate, private lending and hard money financing sees a strong influx of borrowers and can not only adjust rates for even greater returns, but also pick and choose to lend on lower leverage scenarios.
Strategic Investments for a Resilient Portfolio
Staying informed about larger trends and their impact on different assets will keep you in a position to adapt amid inflation.
Review your financial goals—whether you want to prioritize long-term stability or reliable cash flow—and align your risk tolerance. The investment landscape has no shortage of opportunities, and diversification is an essential step in building a strong portfolio.
Consider investments with potential to thrive as inflation and interest rates rise. Read our Guide to Building a Resilient Portfolio to learn more.
