There’s been a lot of fuss on how the “fiscal cliff” will get the U.S. economy into trouble in 2013. For starters, here’s a thorough explanation of how it can impact the economy.
(Video published by the WSJ on Oct. 31, 2012.)
Strategies to Benefit from Inflation
The only “hedge” against inflation that we are aware of that works consistently over time, in any market, and any economy is real estate. Well bought real estate can stand the scrutiny of analyses, using historic or current data, by investing using borrowed money.
To be clear, the ability of real estate to provide a real hedge against inflation only works if you get a mortgage to acquire the property. If you use your own cash, then this capital will be ravaged by the same inflation, and in a similar manner, as if you had purchased anything else.
Although we argue strenuously that there are other benefits of investing in real estate. However, the greater the proportion of the purchase price that is funded using borrowed money, the greater the inflation-beating benefits to you.
And this is where we come to one of those great benefits of real estate that is easy to miss. Since real estate prices are subject to inflation, by borrowing the purchase price (or a large proportion of it) you can largely beat inflation, and real estate is also about the only asset class against which banks and financial institutions will let you borrow money in the first place. It's a marriage made in heaven!
Why Real Estate Investors Love Inflation!
Investors love real estate because it acts as a hedge against inflation. This occurs for several reasons:
One, on an historical basis, housing prices rise just as fast or faster than the rate of inflation. Two, although investors can’t always raise rents to account for inflation (due to fixed-rent leases of one year or more), the value of the property itself will increase. Three, when real estate investors have a fixed-rate loan, expenses will stay the same, and they pay back that loan with money that’s worth less than what they borrowed! In effect, it’s a form of debt reduction. It just doesn’t get any better than that!
Inflation should be moderate in order to benefit investors. Hyperinflation or its opposite – deflation – are definitely bad news for everyone.
The Roots of Appreciation
Even during the Great Depression some people made money. The same holds true today despite one of the toughest economic environments in decades. The key is to understand the roots of appreciation or what causes real estate to go up or down in value. Because all real estate is local, it is entirely possible to purchase a rapidly appreciating property even in a declining industry… in fact, often the property is able to appreciate because of the decline in the industry.
Today we will examine the major elements that cause real estate to appreciate or depreciate in value. Once you understand these simple concepts, it's possible to use each to create your own working checklist when searching for target acquisitions.
- The level of motivation for both buyers and sellers. Although the real estate market as a whole is suffering a decline, there is a substantial need for housing for both buyers and sellers. Many sellers need another place to live and buyers are eager to take advantage of a once in a lifetime buying opportunity.
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Getting Paid to Borrow Money
It is well known that income producing real estate is one of the best investments you can make. What is less well known is that income producing real estate allows you to get paid to borrow money. At least that’s been the case historically.
The reason for this has to do with the reality of inflation. In times of inflation, your best protection against the declining value of the dollar is high quality, long-term, investment-grade, fixed-rate debt attached to a piece of income producing property. In a nutshell, the right kind of debt is good.
Here’s how it works:
Assume that you purchased a property back in 1979 and that a dollar was actually worth a full dollar ($1.00). Then, thirty years later you find that same dollar worth only $0.24 because of continued inflation (driven by the government’s absurd economic policy).
Although the overall purchasing power of the dollar has decreased over those thirty years due to inflation, the principal balance on your long-term debt is never adjusted in step with that inflation. By paying down your fixed-rate debt with continually CHEAPER DOLLARS than those you originally borrowed with, you are effectively saving yourself a lot of money each and every year.
Now, think about it another way:
Assume you purchased $1 million worth of income producing property with a combined mortgage balance of $800,000. And let’s assume that over the course of one year you didn’t pay down any principal and there was a 4 percent rate of inflation. Your loan of $800,000 would now be worth only $768,000 in terms of real dollars. That’s a reduction of $32,000 in one year!
Real Estate Needs Inflation
In the past 36 months Real Estate has seen a decrease in its average mean value, depending on your metro area, an average of 12 to 32 percent. This is referred to as deflation (in economics, deflation is a decrease in the general price level of goods and services). Deflation is not necessarily bad for everyone, especially for new market buyers that need a more affordable housing price in order to purchase.
Ultimately, a stable market economy strives for price stability. In Real Estate this is usually meeting or slightly beating the United States inflationary rate (the opposite of deflation and normally measured with the use of a publicly posted index called the Consumer Price Index). A stable Real Estate market typically lasts many years and almost always follows a Real Estate Recession. In fact the bulk of years within the seven to ten year cycles, represent a stable Real Estate Market. Therefore, 80 percent or more of the historical annual appreciation in real estate has valuation increases at or just above inflation.
For those of you who are business people, you likely seek investments that are stable, predictable, and going up in value each year. The conservative investor should consider buying during Real Estate market cycles that hold a stable future with somewhat predictable results (i.e. less speculative). Such a market is likely to exist for the next 5 years. For those of you sitting on the sidelines wondering when to enter this market, it is time for you to jump in, prior to any inflation, and thereby purchasing at the bottom. Anyone who classifies themselves as a conservative low risk real estate investor should certainly enter the market right now.
What about HYPERINFLATION?
