How Does Investing in Real Estate Hedge Against Inflation? Part I
Let’s face it, friends and readers. Inflation isn’t coming.
Inflation is already here.
The evidence is all around us. Last week’s Consumer Price Index report, well known for understating actual inflation, reported a massive jump.
Those of us who’ve recently tried to buy a car, build a deck, or purchase a home are all too familiar with what’s going on.
Take a moment to Google “inflation”, and you may be shocked at the amount of noise around this term right now.
For those who grew up in the ‘70s and ‘80s, this alarm sounds like an all-too-familiar tome of dread and despair. We recall the gas lines and double-digit interest rates.
We remember grandparents whose pension checks…previously enough to cover two month’s rent…now only covering two weeks.
We recall stagflation, a time where both staggering inflation and interest rates paralyzed our national economy. And ravaged lifetimes of savings for millions.
Ronald Reagan voiced what we were experiencing when he said:
“Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hitman.”
So, inflation must always be bad, right?
NO.
Harness Inflation to Help Protect Your Assets and Wealth
This is part one of a two-part series on harnessing the multi-faceted power of real estate to hedge against the ravages of inflation.
Please note that there are multiple asset classes and methods that have historically beat inflation, but since I am a real estate investor and have been for the past 20 years, I will be focusing on real estate in this article. I happen to think that commercial real estate is one of the best hedges against inflation (if not the best, by some metrics).
So, what do you believe about inflation? I perused the internet and polled a few people around me. Here’s what I read and heard…
Inflation is always disastrous (see Reagan quote above).
Inflation will destroy my savings (see grandparents above).
It is something that happens to me (I’m a helpless victim of the system).
Hyperinflation is inevitable (after all, in the past 13 months they just printed 30% of all the US currency ever circulated).
I had to chuckle when I wrote that last one. In a prior decade, I worked for author and economic pundit, Don McAlvany. I wrote a letter for him during a financial crisis that started off like this…
Read Every Word of this Letter…or You’ll Soon be a Billionaire…Who Can’t Afford a Cup of Coffee!
Don was serious. He was warning about the potential ravages of hyperinflation. It’s happened around the world, and we’re not immune from it here.
I also quoted the great economist, John Maynard Keynes, in that letter…
“Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth.”
I’m not writing about hyperinflation today. I don’t think that’s in the cards. But I do believe we’re beginning to experience inflation that could wipe out the uninformed.
Inflation is a great transfer of wealth from the uninformed to the informed. My goal in this article is to be sure you’re informed.
The Cantillon Effect
Have you heard of the great 17th century economist Richard Cantillon? Cantillon postulated that inflation benefits those closest to the money. The creation of money.
The power brokers of the world will benefit from the inflation they’re creating. The poor and uninformed will be the victims. It always happens that way.
It’s beyond the scope of this article, but I can tell you that our government must inflate the currency to have a hope of paying off our massive debts, including international and unfunded liabilities. And the power brokers on Wall Street, at the Federal Reserve, and in Washington will line their pockets along the way.
But we’re not helpless victims.
Without harming the poor or anyone else, we can align ourselves with the rich and powerful by wisely investing in hard assets.
In a few sentences, here is why commercial real estate can be such a powerful hedge against inflation…
In a subdued interest rate environment, the owner’s largest expense (debt service) remains low and constant, while revenue and asset values rise with inflation. And profits can be extracted tax-free along the way to fund the acquisition of more assets.
As a landlord, you can raise rents to keep pace with inflation. Your banker cannot. The expanding gap reflects your growing profits. And the use of equity compounds your wealth. Check out this brief analysis from BiggerPockets blogger Dave Meyer…
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.”
If you don’t read on, you’ve got the essence already. If you want to understand this in more detail, please continue.
Here’s the formula at a high level (it’s quite simple, and you’re probably already doing it to some degree)…
Invest in cash-flowing real estate assets with intrinsic utility. Finance it with low-interest, fixed-rate, long-term debt. Let others pay off your declining-cost mortgage while you deduct the interest. Safely harvest lazy equity along the way. Allow inflation to increase your cash flow and the value of your assets.
“Hold on,” I hear you saying. “Lots of investors do that. Why is that so special? How does that align me with the great powers of the world behind the curtain?”
Like I said, it may be simpler than you think. But the vast majority of Americans haven’t caught on to this. I can assure you the Forbes 400 wealthiest Americans have been doing this for decades!
Even speculators can partially benefit by applying this principle to their personal residences. Many are doing that already without knowing it. (Even a blind squirrel finds a few nuts, right?)
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Breaking Down This Formula
Invest in real estate. Whether it’s a residential home, warehouse, land, a mobile home park, or a self-storage facility, real estate has consistently been one of the greatest wealth-generating asset classes in world history. Real estate is the playground of the rich and famous.
Invest in cash-flowing real estate. Speculations that don’t produce cash-flow (like Bitcoin) are fine. I’ve got some myself. But wealth is sustained over generations by investments. And investments are generally defined as assets that produce income.
…with intrinsic utility. It’s hard to find great real estate deals right now. It’s not necessary to find assets with value that exceeds their current utility. But seeking out intrinsic utility provides great downside protection and supercharges the upside as well. You can check out my thoughts on this right here.
Finance it… Safe leverage can multiply your returns.
…with low interest…. Did you know that interest rates are the lowest they’ve been in about 5,000 years? It’s true. They’ve done studies showing that rates in this era are lower than any period since ancient Egypt. This opportunity may not last but it’s here today.
…long-term, fixed rate debt. Lock it in for as long as possible. This is probably 30 years for residential. Commercial can often go up to 10 or 12, but there is a unique FHA multifamily product locks in rates for 35 years. Imagine your tenants making your last payment in 2056. Speaking of tenants…
Let others pay off… Inflation works for you when you pay your mortgage. I’m doing this, and you probably are, too. But how sweet when you have others paying off your debt while you sleep. Warren Buffett said, “If you don’t learn to make money while you sleep, you’ll have to work until you die.” It’s a beautiful thing.
…your declining cost mortgage. Just as an example, let’s assume a typical American home cost $18,267 in 1972. Let’s also assume that a typical mortgage was $14,614 at 7.37% and carried a payment under $101. After inflation, let’s assume that same typical home was $77,294 (2002). But the fixed mortgage payment was still under $101. How do you think that payment felt in the later years of that 30-year term? Quite minimal, I would guess. Of course, taxes, maintenance, and utilities rose with inflation. But the original debt service is locked and loaded for the duration.
…while you deduct the interest. Tenants don’t deduct rent from their income on tax returns. Landlords and other commercial investors do. Along with maintenance, capital expenses, and depreciation. Have you ever wondered why real estate and business owners often pay less tax than their employees? It’s true.
Safely harvest lazy equity along the way. If the Fed follows through on keeping interest rates relatively low, and inflation really does drive up the value of your property, you should have the opportunity to withdraw a lot of equity along the way. Tax-free. This is often done through cash-out refinances of some sort. I recommend a fixed rate if possible, but even floating rate debt often provides a great opportunity to pull out that lazy equity and put it to work. You may be able to leverage a single property to put down payments on multiple additional assets with no more cash out of your pocket.
Allow inflation to increase your cash flow… Inflation raises the cost of everything. Including rent. This is one case where not locking into long leases can be a bonus (for the landlord). Higher cash flow and higher costs may sound like a wash. But recall that your banker gets no benefit from this inflation (if you locked in your rate).
…and the value of your assets. It’s just math. Substantial inflation will result in a substantially higher “nominal” (in name only) property price. This doesn’t mean the “real” (non-inflation-adjusted) value will be any higher. But the fact that someone else (or even you) is paying off your home with declining value dollars is a wealth-building exercise. And the fact that you can extract equity (likely two or three times per decade) to acquire more assets is a major bonus.
And while I mentioned taxes briefly in point nine above, I should also mention other potential tax benefits. For example, you may have heard of the 1031 exchange. This allows investors to trade in one investment property for another without paying capital gains and other deferred taxes until a later sale.
But did you realize you can extend a series of 1031 exchanges down the road until your passing? And did you know your heirs may be able to reset their basis, so they never pay taxes on the series of gains you’ve made over decades?
Many real estate investors also take advantage of the Qualified Real Estate Professional designation. This allows them to use some real estate tax losses against their real estate income and their other income. Even W-2 income. Some W-2 high earners even convince their spouse to attain this status.
Though I’m targeting investors in this article, note that both cash flow investors and those investing in a private residence benefit by writing off interest on their tax returns. This makes a sweet situation all the better.
Who?
Who can take advantage of this unique window where inflation is heating up and interest rates are historically low (with tax benefits as a bonus)? We believe that most real estate investors can, including…
Active and passive investors
Residential and commercial investors
Homeowners and those investing for cash flow
U.S. and foreign investors
How?
We’ve covered the theory of creating wealth in an inflationary environment. My next article will drill down on the nuts and bolts of getting this done.
If you have further questions, please email us at invest@wellingscapital.com or use this scheduling link to set up a call.
For educational purposes only. This presentation is not to be considered investment advice 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. Any graphs or charts within are not intended to and do not reflect the performance of an actual account managed by Wellings Capital or the performance of any Wellings Capital investment.
