5 Strategies to Benefit from Inflation | PREI 008
Inflation normally results from government policies which create inflationary pressures. The result of inflation can be best described as more money chasing fewer resources. The sad reality is that for most people inflation truly is detrimental and a silent theft.
Real estate investors are in a unique situation whereby they actually 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. But how?
When you understand what inflation is, and how it benefits you as a real estate investor, you will want to build your real estate portfolio to take advantage of these powerful wealth building concepts.
In this episode we explore inflation and why it’s your friend. We also give you five (5) simple strategies to benefit from inflation in any market.
We also take a look at another turnkey investment property available in our Deal of the Day segment.
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5 Strategies to Benefit from Inflation
Today, we are going to be talking about the exciting subject of inflation. Now, before you turn this off or shake your head and wonder how inflation can be exciting, keep listening because you will find out that inflation is actually your friend. You will see how it can be profitable for you in real estate. Let’s just lay a little bit of background here. The American economy has been bumping along pretty much since 2008. We haven’t really had a real economic recovery. Real estate markets have seen some activity here, especially in the last three to five years. We’ve seen considerable appreciation in many markets. But outside of the real estate sector, the economy has been relatively sluggish. This has forced the government to step in with various monetary policies that have done nothing more than create pent-up inflation. Some people are seeing it. We do have a bit of a deflationary environment, so you do see prices in some things like oil, recently, gasoline, technology coming down. But for the most part, if you look at your daily expenses, energy, housing, food, various consumer goods, those prices have been going up, so we do have an inflationary environment. At the same time, we have government policies that are creating pent-up inflation that we haven’t seen fully bloom at this point in time. The fear is that in the years to come, that could bring on rampant inflation.
I am not a big fan of these government policies, the quantitative easing, the money printing that the Federal Reserve has been on, let’s call it a massive binge, since 2008. Inflation is just one of those things that are a reality. Now, when investors hear the word inflation, in fact, when the general population hears the word inflation, for many, it just sends shivers down their spine. They just hear inflation and they just think that everything is going to be more expensive. That it’s eroding their savings. It’s going to make saving for retirement even more difficult. Those things are generally true, but that doom and gloom is not all that inflation is about. Inflation is much more than that. If you are on the right side of the equation, you can benefit from inflation. At the end of the day, inflation’s effects are pervasive and they’re very subtle. Most people don’t realize that inflation is eating away at their purchasing power every year, but it is there. What you do is see a shrinking pay check. You see your purchasing power of your income get eroded, and that just translates to increasing costs for gas, energy, housing, food and other essentials. Let’s dive in and take a closer at inflation. Let’s define it and look at the cause and effect and how you could benefit from inflation as a real estate investor.
Inflation normally results from government policies that create inflationary pressures. What does that mean? The result of inflation can best be described as having more money in the system chasing fewer resources. Now, this is economic speak and many people won’t understand what that means. Think of it this way. The basics of economics are supply and demand. When you have more money or more currency being created and put into the system, those dollars have to go somewhere. They just can’t sit idle. They have to be parked somewhere. They have to go into someone’s account. They have to purchase things. When you have that increasing supply of dollars chasing the same amount of goods and resources, what happens is that demand for the purchase of those supplies pushes prices up. That is what we call inflation. Now, it’s hard to wrap your head around this. A lot of people don’t understand it at first blush. But if you have a basic understanding of economics, it should make a little more sense. Hopefully, by the end of this episode, you will better understand inflation. You don’t need to be an economist to understand how inflation can benefit you or how it affects you.
There are a couple of causes of inflation. First, you have monetary inflation. Monetary inflation is the increase in the money supply and the basic cause of inflation. As I said, at least in the United States, you have a Central Bank, the Federal Reserve that was created back in 1913. It has the ability to affect interest rates as well as it has the ability to create currency and put that into the banking system, into our economy. As the Federal Reserve prints more and more money, it increases the supply of that money and that just ends up stimulating more demand for the goods, commodities and services that are out there. That supply and demand equation is what pushes prices up. The problem here is that demand increases before there is any change in the supply. You have increasing demand and supply that stays the same or lags behind. What that leads to is price inflation. That’s what happens when you start increasing the monetary supply or the money supply. This is the market’s natural reaction to monetary inflation.
As the Federal Reserve creates more currency, puts that money into the system, the purchasing power of the money in circulation is reduced. By reducing the purchasing power and credit, that ends up pushing prices up so that price inflation, in other words, the prices you see going up in everything that you purchase, is a trailing reaction to monetary inflation. That difference that you see between the two is what we call real inflation. That is the actual measurable amount of increase in the prices that you pay for everything. If we talk about real inflation being 8%, that means that a basket of goods has gone up on average 8% over the course of time, and usually measured in a year’s time.
Inflation is nothing more than institutionalized theft. The sad reality is that for most people, inflation truly is detrimental. It is a silent theft. The exception is in astute real estate investor. The reason why inflation is so devastating is easy to see. Imagine for a moment that you saved $100,000. Today, this sum of money can buy you the car that you want to acquire. It could be anything else or a combination of items that you want. But to simplify things, we will use the example of a $100,000 car. If over time, inflation is greater than the after tax return on your $100,000 investment or savings, then you will no longer be able to afford that car. Your investment may have grown say to $120,000 after tax, but if the price of the car has risen to let’s say $140,000 because of price inflation, you are now worse off, at least in today’s dollar terms, than you would have been when all of your investment can be used to purchase that car.
There are more subtle reasons why inflation is so detrimental to the population. If inflation affected everything equally, then theoretically no one should be worse off if prices went up at the same rate as our salaries, wages and other sources of income. But using the same car example, let’s say you earn $50,000 gross and paid 20% tax. Then you would earn $40,000 after tax. Assuming you have no other expenditures, it would take exactly two and a half years to earn the money required to buy that $100,000 car. The problem with this scenario is that very few countries in the world have a flat tax rate. Instead, tax rates are progressive, meaning that as you earn more, you pay more in tax. The tax rate may well be 20% on a $50,000 gross income. But if your income were to double to say $100,000, then your tax rate may increase from 20% to say 40%. In this case, you would only keep $60,000 each year after tax. Now, if the price of that car also doubled through inflation to say $200,000, then it would take 3.3 years to earn the money required to buy that same car.
In other words, with a progressive tax system in place, even if your income rises at the same rate of inflation, you will still be worse off as the government gets a greater proportion of your income than before because you are in a higher tax bracket because of the fact that you have higher income. I happen to be in favor of a flat tax system. But the tax system that we have is a progressive tax system, meaning that the more you earn, the more you pay. Using the car example, if you earn $50,000 in gross income and you pay 20% in tax, then you would have effectively earned $40,000 in after tax dollars. Now, let’s assume for a moment that you have no other expenses. It would end up taking you two and a half years to earn enough money to but that $100,000 car. The tax rate may be 20% if you earn $50,000. But if your income doubled to $100,000 as a result of inflation, then your tax rate is not 20% anymore.
However you look at it, inflation is devastating to communities, individuals and economies. What does this mean for the real estate investor and what can you do about it? All economies go through cycles and inevitably, our economy will turn around and we’ll see good times again. But we are not there yet. We have an economy that’s on life support. It is being resuscitated by the Federal Reserve and all the money printing. Our government has borrowed literally trillions and trillions of dollars to help salvage our economy. Many other countries have done exactly the same thing. It is not new. Any country that has a central bank, whether it be Japan or Europe, in the Eurozone, have printed hundreds of billions of dollars, if not trillions of dollars.
As our government prints more and more of these dollars, which again is monetary inflation, this eventually decreases the value of our dollar. Our dollar is worth only about 97% what it was worth back in 1913. If you compare what our purchasing power is today versus what the dollar was worth back in 1913, it’s only about one to three cents, depending on whose numbers you look at, but it’s a very, very small amount. Your dollar buys less and the cost of everything you buy goes up, which is price inflation. The government benefits as it eventually pays off its debt in cheaper and cheaper dollars. This is a lesson to be learned as a real estate investor because why can’t we do the exact same thing? The good news is we can. See, many economists agree that inflation will come back. I believe it’s already here and it’s being underreported by the Federal Government. They say that inflation is anywhere from 2% to 4%, depending on what quarter you look at. But the reality is if you look at the real price of goods and services, they are probably closer to 8% to 10%, if not more. This is not good news for the average person. This is not good news for the average American, unless you are an astute real estate investor of course.
Warren Buffett from Berkshire Hathaway told their shareholders that all these bail outs from the US government to the banks and other businesses will do nothing more than bring on an onslaught of inflation. I personally predict that the government will come out with another round of QE, QE4, call it whatever they want. But later this year, I personally believe that they are going to start printing money again because they just can’t stop. They just can’t stop because it will send the US economy into a downward spiral, and that’s the last thing they want. In fact, what the Federal Reserve and the government fears most is actually a deflationary environment. That will be the worst thing. It would cripple the economy and would make the government debts that they have, the $18 trillion plus that they owe plus all the unfunded liabilities. Those debts would become much more expensive because if the value of the dollar didn’t go down, if it went up, they have to pay it in more expensive dollars. But if they have this machine where they can devalue the dollar and create more inflation, they are able to pay their debts in cheaper and cheaper dollars.
You should do the same thing. If you own residential real estate, income producing real estate in different markets, these assets increase in value during inflationary periods. Not only that, but surviving and benefiting from inflation is really a simple matter. If you own inflating assets, in other words, assets that increase in value with inflation, and you pay those off with deflating dollars, meaning that those dollars are becoming worth less and less as time goes on through the effects of inflation, then you are actually benefiting on both ends on that equation. Borrowers win by acquiring appreciating assets and paying them off with depreciating dollars. On the flipside of that is these cycles are disadvantageous to savers. In other words, savers are losers because the value of savings and funds held in fixed return investments and assets become less and less. You can’t keep up. You lose. You can’t keep up with inflation.
We’ve been seeing inflation for a number of years now, especially since around 2010 to 2012. We’ve seen it in the real estate market. That’s a very significant backdrop to appreciating property values in real estate. We’ve seen it especially in the last two years. But if you, as an investor, increase your portfolio by buying more income producing real estate, you will see the value of that portfolio increase dramatically in the years to come. I really think over the next five to ten years, you will see a dramatic increase because of the inflationary pressures that are coming. If the financial crisis has taught us anything, it’s that we need to start taking a different approach to money and how we value it, how we accumulate it and how we use it. Things don’t look positive for many people. This is not true if you are a real estate investor.
Baby boomers are going to be particularly affected. They were planning to retire over the next decade or so, on the savings that they have accumulated, on their retirement accounts. But boomers now find their nest eggs depleted unfortunately and inadequate to provide the lifestyle consistent with the lifestyles they have been used to. Unfortunately that’s just going to continue to get worse. This is why we see so many baby boomers and seniors now starting to work in part time jobs at Starbucks and various other venues just to keep up with their living expenses. Because inflation decreases the value of our dollars, life will become more and more expensive as we move forward through this inflationary environment. I think it’s just going to continue to get worse. What you need to do is inflation-proof your assets and inflation-proof your savings.
Real estate is the answer. Real estate investors are in a unique situation where they can actually benefit from inflation. One of the many benefits of investing in real estate is that you can borrow the money required to acquire the properties. This is leverage. You can borrow up to 80%, sometimes more, of the cost of that property. Consider this oversimplified example. Let’s say you acquire a property with 100% financing. Assuming you borrow $50,000 to buy a $50,000 property that generates $5,000 in rental income. If over the course of time, inflation kicks in and doubles the price of everything, the rents, let’s say, have increased to $10,000 a year and the property itself is now worth $100,000. The return on that property over the course of time has effectively stayed the same. It is still 10%. The rental income is still 10% of the gross purchase price of that property. But what you are failing to see here, and this is where logic misses the point, that inflation pushes prices up on everything except the price of the mortgage.
Your mortgage has stayed the same. Your mortgage was originally $50,000. Assuming for the moment that you didn’t pay off any principal, then it still would be $50,000. In other words, you now have a property generating $10,000 a year and it’s worth a $100,000, but you only had $50,000 of debt to secure it. You have created another $50,000 of equity from the generous contributions of inflation. It is like that $50,000 has come out of nowhere, just appeared out of thin air, but in fact the reality is it’s been generated by inflation. The reasoning for this is very simple. Real estate is closely correlated to inflation and the reason is because the components that make up the property are all subject to inflation. The plumber’s labor, the contractors that worked on the property, the cost of the paint, the copper, the concrete, the asphalt, these are all items that go up in price as inflation goes up. Again, they are closely correlated. The only hedge against inflation that has consistently worked overtime, in any market, in any economy is real estate.
Investing in real estate is using other people’s money to pay for an appreciating asset, which is the property. To put it in another way and just to be really clear, the ability of real estate to provide a real hedge against inflation only works if you raise a mortgage or get a mortgage to acquire the property. If you buy a property all cash, then this capital will also be affected by the ravages of inflation, in a similar manner as if you had bought anything else. The key is to buy income producing real estate with leverage or using debt. This is one of those great benefits of real estate that sometimes is easy to miss.
What are the strategies that you could use starting today to benefit from inflation? First, lock in your mortgage interest rate. I love 30-year fixed rate mortgages. If you are in the US and you qualify for conventional financing or some of these mortgage products where you can get a long term fixed rate mortgage like a 30-year, I’ve even seen 40-year mortgages, that is the best deal going. Mortgage rates can fluctuate dramatically, especially during inflationary times. The best thing to do is to fix your interest rate for as long as possible when they are low. Currently, they are at historic lows. In the US, it is possible to have these rates for as much as 40 years. It is the best thing to get in terms of acquiring income producing real estate.
Don’t get seduced by some of these adjustable rate mortgages if you can avoid it. If it’s for a short three-year hold, I can understand that. But the interest rate difference is sometimes only a half point, maybe a quarter point. It’s just not enough difference between an adjustable rate mortgage and getting a 30-year fixed rate. The gains are just going to be wiped out over the long term. You are better off just locking in with a 30-year fixed mortgage. Let your tenant pay it off and you pay off that mortgage in cheaper and cheaper dollars as the years go by because of the effects of inflation. Bottom line, lock in your interest rate for as long as possible.
Number two. Never sell. This is one of my biggest regrets. I actually purchased a property when I was eighteen years old, held it for a few years and I thought, “I will just take the equity that grew in that property and move on.” I sold the property. Looking back, I should have kept it. It was about a $40,000 property that today is worth about $400,000. That just goes to show you the effects of inflation in a healthy market. Inflation rewards people who hold on to their real estate through two mechanisms. First, with inflation, rents tend to go up. Cashflows improve, making mortgages easier to service. Second, as a result of increasing rents, capital values also go up as well. When you sell your property, you never earn another dollar of rental income or reap the benefits of another dollar of increased equity. Plus, if you sell, you probably will have to pay capital gains tax, and depreciation recapture tax. Not selling your property is a strategy that has stood the test of time.
Number three. Avoid paying off your principle. People seem obsessed with paying off their mortgages, even deploying mortgage acceleration tactics to pay off their mortgages even faster. This is an area of great debate and there are two schools of thought, two camps if you will, that I will discuss in another episode. The reason for this is very simple. Mortgages are borrowed funds and inflation decreases the value of what you have borrowed. Of course, the size of that debt will remain the same, a million dollars is a million dollars of borrowed capital or mortgages. But it will be much easier to come up with a million dollars in 30 years from now because of inflation than it is today.
To put it another way, if you have a million dollar mortgage today and you suddenly won the lottery for a million dollars, would you be financially better off taking the winnings from that lottery to pay off the mortgage or use the lottery winnings as a down payment on another $5 million dollars worth of real estate? Buying the real estate will be much, much smarter. If everything holds true, then you should be able to buy approximately $5 million dollars worth of real estate. Principle repayment is not tax deductible, but the interest payments often are. You are better off getting more income producing real estate, increasing your cashflow, having a larger portfolio of appreciating real estate, and taking those mortgage payments or interest payments as tax deductions against that income. To put it in another way, inflation increases the value of your properties and decreases the value of the money that you used to borrow to buy those increasing assets.
Number four. Choose properties in high growth areas for the best investments. As I’ve mentioned in previous episodes and as we’ll talk about further on, there’s a direct correlation between population growth and the value of real estate. As markets increase in jobs, job growth and population growth, it pushes up demand for housing and that pushes up property values. Unlike trends in the stock market which can appear and disappear in a week, a day, or even a matter of minutes, the growth trends in real estate tend to be very long term. They are easy to track, easy to take advantage of. Often, they are quite easy to spot well in advance because real estate moves very slowly as an asset class. As you probably know by now, the benefits of inflation are far more dramatic on real estate in high growth markets.
Last but not least, number six. There really is no time like the present. The best time to be investing in real estate is now, and I could say it was even yesterday. The fact is that we have been afforded a great opportunity here. The government is hell bent on pushing an inflationary environment to fight off deflation. We have interest rates that are near historic lows. We have property values that in many markets are still below replacement cost. The best time to take action is now. Everything is in alignment for you. What we have at the present time is literally a perfect storm. If you are an astute investor, if you can get into the game, even if you don’t have a lot of capital or a lot of resources and particularly if you don’t have a lot of time, which is the reason we are here to help you, you can get into some income producing properties for $50,000, $60,000, $70,000, $80,000 in purchase price, which means that you only need about $10,000 to $20,000 in investment capital.
The astute investor will benefit tremendously while others who just sit and watch or hesitate, will wonder what happened, they’ll watch a spectacular opportunity pass them by. I’ve said for many years, there are three kinds of people in the world. There are those that make things happen, there are those that watch things happen and then there are those that wonder what happened. Don’t be that third person. Get out there. Start building your real estate portfolio. Do yourself and your family a favor. Get out of the rat race. Build your financial future and build your financial freedom.
If you need some help, feel free to give us a call. Contact one of our investment counselors, that’s what we are here to help you do. We would love to help you. Even if we are just having a conversation about it to help you with your strategy, that’s completely fine with us. We love this subject. We love the topic of real estate investing. We love the topic of financial well being and we want to help you create your wealth and build your cashflow.
I know the subject of inflation is a rather complicated subject for most people. A lot of people have a hard time wrapping their mind around it. But it is something that affects us every day and it affects everybody on multiple levels. You can take advantage of that. If you are a real estate investor, you could definitely be on the right side of the equation to take advantage of the effects of inflation in your favor.
That wraps it up for today. Remember to visit our website to download our free report, The Ultimate Guide to Passive Real Estate Investing. Just go to PassiveRealEstateInvesting.com. If you have a question or a topic suggestion, give us a call, send us an email or you could even leave us a voicemail on our website. Thanks for the great reviews that have been coming in. We really appreciate that. They have been great. It helps us spread the word. Thanks for listening. We really appreciate you being here and we will see you on the next episode.
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