From Gerd Kommer and Marcel Lauterwasser
The world of investment has probably produced more fairy tales than the two Grimm brothers were able to collect in five decades. One of these fairy tales is the “theory” that real estate service providers and financial journalists have been promoting for decades that inflation is good for borrowers because it “inflates away” the real value of debt. This “theory” is expressed in the following quotes:
"Inflation benefits debtors and harms creditors. Because with the devaluation of money, the real value of claims also shrinks." — Wirtschaftswoche
"Borrowers benefit from high inflation. When the value of money decreases, the debt burden automatically decreases." — The Berlin real estate service provider Living happiness on his website
“As a real estate borrower, you benefit from rising and sustained inflation as the real value of the debt falls.” — The real estate loan broker Dr. Klein Privatkunden AG on his website
“If an inflation rate of 5% lasts for four years, then a fifth to a quarter of your home loan will ‘magically’ disappear.” — New Zealand property services provider OneRoof on its website
“In the event of increased inflation, the loan financing is diluted to the benefit of the borrower because the value of the loan to be repaid loses more value than with normal inflation.” — From the guide book “Practical Guide to Real Estate Acquisition and Real Estate Financing”
The facts look different.
For the majority of all borrowers, inflation has neither a significant positive nor a significant negative effect over the term of their loan. For a minority, inflation is about equally likely to have a financially beneficial or detrimental effect.
Story time in the real estate industry
why this Inflation-is-good-for-borrowers fairy tale from the real estate industry and the media is wrong, we explain below using economic logic and historical data.
The main reason for the lack of veracity in storytime can be summarized as follows: At any given point in time, the inflation expected by the market in the future - the next twelve months or the next 20 years - is already priced into the interest rates on real estate loans (and bonds). To the extent that future inflation is priced into the expense interest, it cannot have a real inflationary effect - whether high or low - because the negative effect on the interest to be paid and the positive effect on the inflation of the balance on which this interest accrues over time cancel each other out.
The inflation expected by the capital market for the future and thus already priced into the expense interest rates and income interest rates can simply be derived from the difference between the current yields on conventional government bonds and inflation-protected government bonds - for any period over the next 30 years. We have the background to this in this one YouTube video and this one explained.
Although it can be off the market ex ante Estimated inflation priced into interest rates for a single year or longer single period may later turn out to be too high or too low, but the market estimate is not systematically too high or too low. It is surprisingly correct on a long-term average – see this YouTube video.
Among economists, the pricing of market inflation expectations into the nominal interest rates of loans or bonds is part of the canon of undisputed basic findings in financial market research.
If the expected future inflation - whether high or low - is already included in the market interest rates and these estimates fluctuate symmetrically on average around the actual inflation rates that will later be realized, then in the long term neither loan borrowers nor bond investors will collectively benefit from inflation. The advantage of paying off the fixed loan from income that increases every year by the inflation rate is offset by the disadvantage that the loan interest is exactly this inflation rate higher than in a world without inflation. Overall and in the long term, the economic essence at the level of all lenders and borrowers is as if there were no inflation at all.
You don't need to be a qualified financial economist with specialist knowledge of the market's inflation expectations to understand this issue - a little common sense will do the trick.
If it were true that borrowers systematically benefited from inflation, then it would also have to be true that lenders were systematically harmed by inflation. Lenders in an economy are primarily banks and institutional investors such as insurance companies and investment funds that invest in loans or bonds. The idea that these professional market participants allow themselves to be ripped off by their debtors worldwide and permanently - this idea seems absurd.
A look at historical data makes the economic logic at work here visible. The following figure shows the development of real estate loan interest rates and inflation in Germany in the 53 years from January 1970 to March 2023.
Figure: Real estate loan interest rates and inflation (CPI) in Germany from January 1970 to March 2023
► Interest: German real estate loan interest with a ten-year fixed interest rate. ► Inflation = consumer price inflation. ► In order to smooth the curves and thus make the basic tendencies more visually apparent, the moving average of the previous 36 monthly values is shown for both variables. ► Data: Bundesbank
The graphic shows that real estate loan interest rates and inflation develop quite parallelly in the long term. When inflation rises, loan interest rates tend to rise at the same time; when inflation falls, interest rates tend to fall. The correlation coefficient between the two data series shown here is a relatively high + 0.65.
Individual borrowers can benefit from the fact that loan interest rates and inflation rates do not run exactly in parallel over time, but about the same number of others will suffer a roughly equal financial disadvantage due to the imperfect synchronization. For the majority of all borrowers, there will be neither a serious advantage nor a disadvantage over the entire term of their fixed-rate loan, which usually runs between 20 and 30 years until it is fully repaid and undergoes one or two further interest rate adjustments in between.
A constellation in which the market underestimates subsequent inflation (i.e. initially pricing too little inflation into the loan interest rate) is advantageous for the borrower; a constellation in which inflation is initially overestimated is disadvantageous. In the latter case, the interest burden of such an unlucky person is higher than it would have been if the market had correctly priced in inflation.
Why don't we see the economic logic?
One reason why even financial journalists and many business-savvy people do not understand this financial market logic is that they incorrectly only look at the repayment aspect, i.e. only take into account the beneficial half of the inflation effect. However, its disadvantageous side – the increase in the interest burden – is forgotten or ignored. Of course, this cannot result in a correct overall result.
Whether inflation benefits or harms an individual borrower over the entire term of his loan depends, on the one hand, on the specific historical constellation and, on the other hand, on the length of the interest rate fixation on his loan. Regarding the length of the interest rate fixation: Anyone who takes out a real estate loan with a variable interest rate - the shortest possible interest rate fixation - will very likely have a zero effect from inflation. Anyone who takes out a loan with a ten-year fixed interest rate can either benefit from great inflation-related benefits or suffer great damage.
Since inflation in Germany (as well as most other Western countries) fell trendily and significantly over 40 years from mid-1981 to the end of 2021, one could speculate that most borrowers with long fixed interest rates suffered a financial disadvantage from the actual development of inflation over these four decades.
Galloping inflation or hyperinflation
A special variant of the Inflation-is-good-for-borrowers fairy tale states that runaway inflation or hyperinflation would cause borrowers to lose their debt quickly or even overnight. The fact is that no Western country - where governments are also dependent on the support of the poorer half of the population - will tolerate any significant benefit to property owners due to high inflation.
Let us look at the course of a “historical field test” in Germany, namely the hyperinflation from 1921 to 1923. In fact, it initially led to real estate borrowers at the time being completely relieved of debt in a very short period of time without making any contribution of their own. Salaries, corporate profits and real estate values increased tens of thousands of times in a very short space of time, while loan balances remained unchanged. This meant that any loan could be repaid with complete ease. This initially seemed wonderful for borrowers – a “windfall profit” for all debtors.
For the larger, poorer part of the population, however, hyperinflation was an economic catastrophe. This population group did not own any significant material assets and had previously been unable to take out loans to finance them due to a lack of creditworthiness. If these households had any wealth at all, it consisted of cash and bank deposits. [1] Its real value shrank to zero due to hyperinflation. At the same time, the unemployment rate shot up, ruining even more worker households.
In this economic chaos, immediately after the end of hyperinflation in 1923, the then Weimar Reich government used a package of measures to remove the benefits given to real estate landlords in general and real estate borrowers in particular from the hyperinflation and the inflation-related elimination of their real estate loan debts: 15% of the pre-inflation debts, which had previously been reduced to zero by inflation, were revived in new Reichsmarks. From 1924 a “house interest tax” on rental income was introduced. The tax rate on the gross rent (not on the rental profit) was up to 40%, depending on the state of the Reich. To ensure that landlords do not pass on these additional costs to their tenants, a rent cap was introduced. These measures remained in effect for 29 years until 1943 and probably eliminated all benefit from inflation-induced debt relief.
Nobody disputes that the misery surrounding hyperinflation in 1922/23 contributed to the events from 1939 onwards. The Second World War saw an unprecedented destruction of real estate assets in Germany. As if that wasn't enough, something else happened afterwards Burden equalization law in West Germany, which primarily affected property owners. In the GDR and the former German eastern territories in what is now Poland, essentially all property owners were expropriated after the end of the war.
In view of these facts, it seems rather naive to believe that as a real estate loan borrower you would be economically unscathed or even benefited from galloping inflation or hyperinflation. That was not the case in 1921 and would not be the case today.
Cui bono?
Finally, the question arises as to why the fairy tale about the inflation away of loan debts, although obviously unrealistic, has nevertheless been spread as truth over and over again for decades. See the quotes at the beginning of this blog post. The answer to this is simple:
For those who earn directly and indirectly from the sale and financing of residential real estate - banks, brokers, property developers, real estate authors, providers of real estate investing courses - the spread of fiction is economically helpful. For financial journalists and YouTubers, the inflation thesis represents writing material whose mention makes them appear competent to the audience.
And because that is the case, the story time will continue to take place over the next 20 years when private households want to find out more about real estate loan financing.
The current situation
Currently, at the beginning of 2023, the German inflation rate of around six percent p.a. exceeds the real estate loan interest rate of almost four percent p.a. At first glance, this looks like a positive situation for borrowers. But even now, just a look at them reveals In totalsituation the actual facts and they look less pleasant. Real estate prices have fallen significantly in real terms since the beginning of 2022 to date (see here). Anyone who bought during this time or shortly before and financed with credit received a severe financial blow in the stomach. The credit leverage effect transforms even moderate price declines at the property level into significantly higher losses at the equity level. In addition, the increase in household income is currently lagging behind inflation, meaning that the inflationary effect is reduced.
The idea that inflation is good for real estate financiers is often not true, even if inflation exceeds loan interest rates.
Conclusion
For most real estate borrowers, inflation of debt will not have any significant positive or negative impact over the entire term of their loan.
The few debtors over whom there is strong influence can be both advantaged and disadvantaged.
If bankers, real estate agents, property developers or “real estate coaches” tell you the dusty fairy tale about the inflation effect, you should interpret this as a warning signal for a lack of competence or excessive enthusiasm when selling.
Endnotes
[1] At that time, the so-called “little man” statistically had no loan debts because real estate loans from banks or building societies to working class and lower middle class households were rare exceptions at the time.