Hello investors and real estate enthusiasts! Thank you for taking the time to read our blog.
Today, I’m writing about a higher-level benefit of real estate investing. Many people don’t tend to know about this hidden gem. It’s known as the counter-inflationary power of real estate. We’re all familiar with inflation, even if we don’t think about it on a daily basis. Well, counter-inflation is another aspect we may not always have on our mind, but can affect our investing goals if approached correctly.
To understand what we’re talking about here, we first must unpack what inflation is and why we want to “counter” it. While many of you understand the process of inflation, I want to briefly explain it to either refresh your understanding or explain it to someone who may not be so familiar with the term.
Inflation is a general increase in prices and fall in the purchasing value of money. There are a few different reasons why inflation happens, but in a simplistic view, inflation occurs when the government prints more money, thus making each dollar worth less. This happens because of the idea of scarcity; if there were unlimited dollars, nobody would want them, but if there were only a few dollars, everyone would want them. Much of this has to do with the fact that we have accepted the dollar as the best medium of exchange for buying goods and services in our economy.
As a quick example, in 1913, a gallon of milk cost about 36 cents per gallon. One hundred years later, in 2013, a gallon of milk cost $3.53—nearly ten times higher. Why? Because the government printed more and more money and that money ended up in everyone’s possession. In turn, we all have a greater ability to pay more dollars for goods and services, which also increases prices. If people can pay a higher price, sellers will certainly charge a higher price. The moral of the story is: if we simply save our dollars while the government is printing money, you are actually losing value each month because you won’t be able to buy as much tomorrow as you could today.
So we’ve now briefly discussed inflation. How does real estate come into place and how do we hedge against it? First, we must understand that real estate is a “good” in itself within the economic market. There is both supply and demand for owning and renting real estate. So on the owner/investor side of the market, prices will go up as more people would like to own and invest in real estate. This is known as appreciation. Also, providing someone a place to sleep, store their belongings, cook their food, and use the bathroom are all human necessities. For the most part, these are things in which people cannot choose to opt out in a property. So, on the renter side of the market, as more money enters into the economy and people have more money in their pocket, they will be able to pay higher prices for rental housing. The intriguing part is the increase in rents each year and how it reflects at least the same rate as the annual inflation rate, if not higher, in a desirable market. If the inflation rate is 2% next year, renters will also be willing to pay 2% higher on their rent next year. This will repeat each year as the inflation rate increases. The real increase in rents is 0% as they are still renting that same house but the nominal increase is 2%. The nominal rate simply refers to the rate before inflation is taken into factor.
Another way real estate has a counter-inflationary power is by the use of leverage. A buyer of real estate can use debt or leverage to complete the purchase. You can put a down payment of 20% on a property and borrow the other 80% to close on the property. The person or entity lending you the 80% is going to charge you interest on the money they are lending to you. To really see the usefulness of leverage, let’s say that the interest rate they charge is 3%. Remember, this rate does not have inflation factored into it and therefore this is the nominal rate. When we subtract an inflation rate of 2% (typically the average rate), we end up with a real interest rate of 1%. This is really useful compared to an investment without leverage. An investment without leverage would not utilize the benefit from the “free money” the lender is giving you. It would also not include any interest charged to you at the 2% mark or below. To make sure this is clear, if anyone will lend you money at the inflation rate or lower, take as much as you can get because that money will degrade in value at the same rate you are required to pay it back. If for some reason someone offers you a loan at 0%, they may be a tad insane. At a rate of 0% they are losing real value and buying power of that money every second you possess it. A dollar today is worth more than a dollar tomorrow.
Let’s do a quick example of a single family investment property in Kansas City, Missouri.The worth is $100,000 on the first day of the year. We rent this house to a tenant for $1,000/month. Our 30-year fixed mortgage interest rate is 3% while the inflation rate is 2%. As we mentioned, appreciation of real estate usually keeps up with or exceeds the inflation rate, so by the end of the year our property is now worth $102,000. By the end of our one-year lease, we also can raise our rents by 2% due to inflation. The tenants are willing to pay more because they likely got a pay raise of at least 2% that year as well. Our monthly rent is now $1,020/month. Lastly, our mortgage interest rate is 3%, giving us a payment of $422/month. At the end of the year, the real value of the dollars we borrowed to buy the house has decreased by 2%, leaving us with a real interest payment of 1%. The year after, the dollars we borrowed to buy the house would again be worth 2% less, and same with the year after that. It is clear how the power of compounding can degrade this amount we owe more and more each and every year we pay it back. Every month that we make a mortgage payment, the less and less real value we are paying back, although the nominal value always stays the same at $422/month.
One of the most influential economists of all time, John Maynard Keynes, said,
“By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”
This is why we must find a physical asset that has a real store of value to keep and grow our money. Real estate is a vital example of real assets and real value.
I hope this read gave you a good general overview of how inflation interacts in real estate investing. My mission is to educate like-minded investors on real estate topics which may not be well known to the general public. For more information on other benefits of real estate investing, watch our 5 Benefits of Real Estate Investing video on our YouTube channel.
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