How Does Investing in Real Estate Hedge Against Inflation? Part II

Remember those charts they showed you? How your $200k mortgage would cost you $555,555.55 to pay off over 30 years. Proving you should pay off your mortgage as soon as possible to beat the bank.  

I’m here to tell you they are absolutely right.

If there’s no inflation. 

There’s a different calculator to use in the case of inflation. And its effect is magnified in the case of high inflation.

It’s possible to use real estate in an inflationary environment to accomplish two life ambitions I’m pretty sure you’ve been aiming at:

1. To irritate Dave Ramsey

2. And to beat the bank at their own game

Oh, and a third ambition you may not have considered…

To become very wealthy in the process.

In my previous article, I explained why the ravages of inflation may actually work in your favor if you know how to align yourself with what I consider to be two of the most powerful forces in the history of planet earth: 

National governments and central banks.  

(You should really skim that article first to prepare you for what I’m about to tell you.) 

Here in the second quarter of 2021, the United States is in the midst of a super-charged inflationary situation. The world’s nations are run by unspeakably greedy and powerful people who are creating systems, structures, and strategies that happen to line their own pockets (sometimes at the expense of the masses).

But as I said last time (when describing The Cantillon Effect) you can easily align yourself with them to create serious multi-generational wealth. Without hurting anyone in the process.

It may sound crass, but it’s really true: The best way to help the poor is not to become one of them.  

You can either curse the darkness…or light a candle. I’ve tried both. I’ve found it’s useless to do the former. I’m here to light a candle and I’m hoping you’ll join me.

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Examples of How to Use Real Estate as a Potential Hedge Against Inflation

I’m glad you asked. I’m going to review five different sets of examples. Each one builds on the previous one, and each one is achievable for most real estate investors. While Part I talked about these strategies in theory, this one boils it down to practice.

You’re probably already using one or two of these already.

Here’s a quick outline:

1. Harness the power of inflation by acquiring real estate.

2. Leverage your returns by utilizing depreciating fixed rate debt.

3. Harvest lazy equity tax-free along your journey.

4. Find someone else to pay off the depreciating mortgage on your appreciating asset.

5. Protect and supercharge this whole process by acquiring assets with hidden intrinsic value.

Harness the Power of Inflation by Acquiring Real Estate

You can buy Bitcoin. It may go up above $60,000. It may plummet below $30,000. It is not really an investment; it is a speculation. It is totally fine to speculate. Some people may argue that Bitcoin is a hedge against inflation. But it’s not really an investment that you can consistently rely on to counter inflation.

Gold has long been viewed as a potential inflation hedge. It’s not a bad idea to have some. But like Bitcoin, it is mainly insurance as opposed to an investment. My gold broker friend teaches this to his clients.

You can invest in antique cars. My friend did that. He has an old Mercedes that was worth about $120,000 a few years ago. He should have sold it. He might be able to get $80k for it today. Not a reliable investment (but better than investing a new Mercedes).

I would argue that real estate is one of the most reliable inflation hedges in world history. Sure, we can say, “everyone needs a place to live” and “they’re not creating any more land.” That’s true. But it goes deeper than that.

Real estate, if utilized properly, provides cash flow. This is how I define a true investment: an asset that throws off cash. This is how true wealth is created.

Here are a handful of examples on how to implement this strategy:

1. Buy a single-family home, duplex, or triplex and rent it out.

2. Buy or invest in a commercial real estate property. This could include multifamily apartments, self-storage, manufactured housing communities, senior living, warehouses, cell towers, and many other real estate asset classes .

3. Stop renting and buy a home if you’re planning to stay there longer than 5-8 years. Or buy a home on a lease-option contract.

Wait…invest in a personal residence? Yep. Even if it doesn’t produce cash flow, cash flow is involved. You’re paying for a place to live, either in the form of rent or mortgage payments. So, the value of your real estate, your rent, and your debt payment is important to your income and your wealth, especially with ramping inflation. Speaking of mortgages…

Leverage Your Returns by Utilizing Depreciating Fixed Rate Debt

There are two ways this is important. First, leverage multiplies your ROI. Second, the debt hedges the declining value of the dollar over time.

Multiplying your ROI is obvious. If you buy a flip home for $100,000, and sell it a year later for $120,000, you make a respectable 20% return. But if you borrow using 80% leverage, you only use $20,000 in cash. Your 20% return-on-asset is elevated to a 100% cash-on-cash gain (less the carrying costs, of course).

Here’s a graphic from BiggerPockets author Dave Meyer, used in my prior article to help visualize this…

From the article:

“At the top, we have two lines. The blue line represents rent growing with 2% inflation annually. The orange line shows what the value of that rent is in 2021 dollars. Remember inflation makes money less valuable, so while rent is going up 2% per year (blue), your buying power stays the same, hence the flat yellow line.

“The opposite thing happens with your mortgage payments. The amount you pay each month stays the same (blue line), but the amount that payment actually costs you in 2021 dollars declines (gray line) because inflation is lowering the value of that money over time. The gap between the light blue line and the gray line is your profit: rent in 2021 dollars minus mortgage payment in 2021 dollars. The gap gets bigger over time, which we like.”

Here are a handful of implementation examples:

1. Lock in a 30-year fixed-rate mortgage on your primary residence. Resist the urge to do 15 years or pay it off early.

2. Obtain a 30-year fixed-rate residential mortgage on a single-family rental, a duplex or up to four apartment units.

3. Trade in your home equity line for a fully amortizing fixed-rate loan while rates are still low.

4. Buy a commercial (large) apartment building with an FHA loan. Let your tenants pay off your declining cost debt over 35 years. (Can you imagine what the value of the dollar won’t be in 2056?)

5. Acquire or invest in other commercial real estate assets that allow you to get around 50-70% leverage and fixed rate debt for a decade or more.

Harvest Lazy Equity Tax-Free Along the Way

Inflation is kicking in. Imagine your personal residence increases in value by $500,000. What is your ROI on that growth? Arguably zero. Or at most, the opportunity cost (opportunity “savings”) on not having a mortgage on that equity.

Here’s what I mean. If you have an 80% LTV mortgage on that equity, you will pay interest on your $400,000 mortgage at today’s going rate. Likely about 3% annually at the time of this writing. Since you’re avoiding that interest, your ROI is effectively 3%. Some would argue that your ROI is zero. Either way, this “return” is probably not keeping up with rising inflation.

You can fix this by refinancing to safely withdraw a large portion of that equity. You can reinvest that equity in higher returning assets.

Think about this…you just harvested your lazy equity and put it to work, like seeds for a larger future harvest. And you paid exactly zero tax for this privilege. Because refinancing incurs no tax. You’re tapping into your equity.

This same principle works for commercial deals. Lazy equity can be periodically extracted with no tax consequence. Increased interest payments are deductible in fact. And this equity can be utilized to invest in multiple projects, increasing your cash flow and expanding your wealth.

Some examples…

1. Extract equity from your personal residence to invest in single-family rentals or passive commercial investments.

2. Refinance the Freddie Mac or Fannie Mae debt on your manufactured housing community (up to twice in the first five to seven years). Use the cash to expand the park or buy another asset.

3. Refinance any commercial asset to acquire more or to reduce your equity in the project. This takes equity, and your risk, off the table.

4. Refinance any commercial asset to buy equity investors out, increasing your equity in the project. This pays off short term investors and increases your equity in the project.

5. Syndicators: refinance your commercial assets to reimburse investors, lowering their investment and potentially increasing their overall ROI.

Find Someone Else to Pay Off the Depreciating Mortgage on Your Appreciating Asset

Warren Buffett famously said, “If you don’t learn to make money while you sleep, you’ll have to work until you die.”

The best real estate investments generate cash flow. This is provided by tenants in the form of rents. These rental payments provide profit for you, but they also pay down and could eventually pay off your mortgage.

In an inflationary environment, debt service decreases as an effective cost, while rents continually rise. This increasing gap boosts cash flow and profitability. And this expands your wealth and provides opportunities to invest in more assets.

I can’t overstate the power of growing revenues with fixed rate debt in an inflationary environment.

The examples for this one are obvious. Any cash-flowing residential or commercial real estate is a possibility.  

Protect and Supercharge this Whole Process by Acquiring Assets with Hidden Intrinsic Value

It’s been hard to acquire multifamily and single-family real estate at a fair price for quite some time. Other commercial real estate types are in the same boat. Paying above an inflated asking price – then praying rents will grow to meet that level – is not a sound business strategy.

So, what’s the answer?

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The Power of Acquiring Assets with Hidden Intrinsic Value

The solution is to strategically acquire assets with hidden intrinsic value. Assets that can be upgraded or repositioned to a different usage to raise revenues and expand value. This is more than just a value-add strategy, though that could be an example of intrinsic value exploitation.

It takes a trained eye to spot hidden value. It takes an experienced team to extract that value. It takes a smart investor to participate. Hopefully that’s you. (I can tell you that this is the only way I want to invest!)

Investing in assets with hidden intrinsic value can provide stakeholders with a wonderful margin of safety. Constant debt payments with rising revenues leads to a growing financial gap. This gap represents ballooning profits and cash flow, but it also creates a safety buffer to hedge against downturns or economic shocks. Inflation should widen this margin even more.

Here are some real life examples (with a few details masked)…

1. My friend, real estate broker Eric Eickhof, helps his investors locate well-placed but seemingly overpriced four-bedroom homes near campus in Minneapolis. These homes don’t cash flow well as single-family rentals. But renting by the bedroom to students generates massive income and value.

2. A.J. Osborne acquired the Reno Super Kmart. He sold off the parking lot to apartment developers, cut the building in half, and converted it to self-storage. He had $2.5 million in cash in the deal plus $5 million in debt. During lease-up, he turned down a $26 million offer from an institutional investor in favor of cash flow and a stronger value later. 

3. An investor bought a Charlotte multifamily asset operating under an outdated rent control law. Rents were around $500 in an area of $1,000+ rents. It took 18 months and a dozen petitions to authorities to remove controls. Once he pulled it off, he was able to raise rents incrementally over several years. He doubled the value of the asset, which more than tripled investor equity.

This intrinsic value strategy can work in any economic environment. But what does it have to do with inflation? Inflation supercharges revenues and value from this process. In the meantime, activating intrinsic value protects investors from downside risk along the way. This is a powerful combination.

Concluding Thoughts

I can’t definitively state that “real estate is the perfect hedge against inflation.” I won’t say that because everyone’s goals are different. And because we don’t know how what will happen in the future.

But I can say that real estate has historically been a formidable store of value and a potent inflation hedge. Buying and operating real estate using these principles can give you a significant advantage as inflation heats up and as those around you scramble in fear.

If you have further questions, please email us at invest@wellingscapital.com or use this scheduling link to set up a call.

This article is for educational purposes only and is not to be relied upon as the basis for entering into any transaction or advisory relationship or making any investment decision. All investments involve the risk of loss, including the loss of principal. Past performance, and any performance results reflected in this article, is not an indication of future results.