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Real Estate as a Hedge Against Inflation

by Ali Boone on December 29, 2012 · 17 comments

  
Hedge against Inflation

Why do houses appreciate? It’s not because they get better with time because they most certainly don’t. They can actually get pretty worn out and require substantial repairs. So then what causes the famous appreciation so many people buy houses for?

Inflation.

The CNN news headline on TV this morning was “America’s economy held hostage!” Merry Christmas everyone, we’re all doomed. At least that seems to be the talk now that the holidays are over and consequently we have nothing better to focus on except this thing they call the Fiscal Cliff. If you haven’t heard that term you are obviously living in hole. It’s on every news channel, in every paper, and I’m actually surprised more sitcoms haven’t made fun of the potential loom that hangs over us.

What is Inflation and Why Do We Need a Hedge?

HedgeWhat does the Fiscal Cliff mean for all of us? I really don’t know nor am I going to try to analyze it here. I am certainly going to hope for the best but I wouldn’t question you if you say we are all doomed either. I do know one thing though: more than ever, I know it’s time for me to be in control of my money. I don’t claim to be a financial expert by any stretch but I do know that if inflation is going to continue, which follows right along with this Fiscal Cliff idea, I want to be smart with my money by keeping it as protected against inflation as I can.

Thinking in terms of Inflation for Dummies, inflation basically means:

  1. More money is created
  2. The value of the dollar goes down
  3. Therefore prices go up

I have $100. The government prints more money. What I can now buy with my $100 is what I could have bought with only $80 before the new money was printed. Translate that to a real-world example: A gallon of milk in 1970 cost roughly $1.15. Today a gallon of milk is about $4.00.

Hello, inflation, it’s nice to meet you.

There are a lot of factors in thinking about where the safest places for your money are. Stocks, CDs, banks, real estate, commodities, under your mattress, in outer space…everyone has different opinions. I’m not here to say what is right or wrong about each option, but I am here to explain how real estate can protect against this little witch we call inflation.

How Real Estate Can Fight Inflation

Real estate is one of the few assets that react proportionately to inflation. As inflation occurs, housing values go up and rents go up. Can you then see why owning real estate may be a good thing? If not, let’s put this into perspective with a simple hypothetical example.

In 2012, you buy a house for $100,000. After the world doesn’t end that year and the government begins to drive off the Fiscal Cliff, the financial markets become a mess and inflation is in full-bloom for the next 10 years. Now 10 years later, because of inflation, this same house is worth $180,000. You now own an $180,000 house that you only had to pay $100,000 for! Sounds like a deal to me. You basically have $80,000 in free dollars now.

Inflation: The Landlord’s Friend?

Let’s take this up another notch. Instead of living in the house yourself, you decide to rent it out and you begin collecting $1,000/month in rent. At $1,000/month you net $300 after the mortgage and other expenses. At the end of a 10-year stint with no inflation, you would have pocketed $36,000 in passive income (woot!). However, thanks to the same inflation that jumped the house’s value over those 10 years, you had to increase the monthly rent by $100 every other year. This would put the amount of passive income you pocketed at $50,000 instead of $36,000 (double-woot!). Although that $50,000 doesn’t take into account any increases to property taxes, insurance, etc., so l am going to put it back down at $45,000 before someone argues me on that one. Regardless, inflation has just put a nice extra chunk of cash in your pocket! $9,000 specifically in this case.

One property in only 10 years, thanks to inflation, has put $89,000 in your pocket you wouldn’t have otherwise had. Actually, it would be more than that once you consider how much you reaped in tax benefits as well, but I’m trying to keep it simple.

Note: Going along with the idea of trying to keep it simple, I acknowledge that I have ignored a lot of factors here associated with appreciation, taxes, income and expenses, but the point is to focus solely on the impact of inflation and nothing else. I also didn’t go with any particular % inflation either but rather used simple numbers to show the point.

If inflation occurs, real estate is one of the only inflation-adjusted assets other than commodities. While most of the population believes real estate is a risky investment, I believe real estate is one of the only safe investments left given our continuing financial crisis.

What about you? Does the Fiscal Cliff drive you more towards investing in real estate or further away from it?

Photo: Glynn Lowe& Son of Groucho

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{ 17 comments… read them below or add one }

Brandon Turner Brandon Turner December 29, 2012 at 3:12 pm

Hey Ali,

Great post! You have a great way of explaining stuff so guys like me (slow…) can understand! :) Seriously, it’s great. It reminds me of why I got into this business. Thanks for the great stuff!

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Ali December 30, 2012 at 7:30 pm

Brandon, I really appreciate the feedback! You aren’t slow, you are just like me- prefer the big picture explanation rather than a mess of intricate details :)

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Dennis December 29, 2012 at 5:40 pm

The Fiscal Cliff is a completely bogus figment of Washington’s imagination.
The Cliff will not make RE go up in value, so investing for that reason is not such a good idea.

Inflation is going to make RE go up in value, price yes, but that is only because it will take a few more semi worthless pieces of paper to buy the same house. Those few more semi worthless pieces of paper are not going to buy you a better property or a nicer anything as those items will also increase in cost due to inflation.

The only reason RE went up to the level it is today is low interest rates.

For example let’s just say you purchase the home or rental property of your dreams. You score a 3% loan the term does not matter, the payment is $3500 a month.
A few years down the road you decide your dream has changed, you want to sell.
But the interest rate now stands at 10% as the Federal Reserve is trying to put a lid on massive inflation cause by QE1, 2, and 3.

Hmm? This same house at 10% interest will have a monthly payment of $10,000. Have wages also tripled? Using history as our guide; inflation alway out paces wages.
So how is one to sell this dream home now at $10,000 a month? Can you say short sale, or subject to the existing financing, or if you were diligent and payed the property off, you could lower the price that would allow one in the same socio economic level as when you purchased it to buy this home.

If you study how people in the USA buy everything; first determine how much they can afford (or want to) each month? That in a nutshell is how Americans buy everything.

If you think me wrong ponder this; what would happen if all credit vanished tomorrow?
How much cash could you rustle up to buy your car or your house? How many Americans could buy anything without low interest credit?

Just a heads up, if the interest rates in the USA are not allowed to go up, exactly how is one to save for retirement? Currently our seniors are wondering if cat food is in their future, treasuries are paying 1.6% and CD’s are paying near the same or less.
The big push of institutional investors into the RE market is solely because there is no interest being paid on their cash savings.

When interest rates go up, institutional investors will dump REI, higher interest rates will also cause REI to go down in face value. The Federal Reserve can only hold down interest rates for so long and then so long to REI appreciation from inflation.

Some advice; make sure whatever you buy you like and make sure it cash flows.
As interest rates go up homebuyers will be locked out of the market and will need to rent. When you are making money on a rental who really cares if the price goes up or down?

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Ali December 30, 2012 at 7:37 pm

You are correct, Dennis. Most important thing- cash flow, period. No crystal ball of appreciation should ever be used. Good thoughts worth consideration in relation to interest rates. I’m not sure I agree on the only correlation to prices being that with interest rates, but I’m willing to put some thought into your points.

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Nick Nelson December 30, 2012 at 12:13 am

I agree with most of the the content and believe this post was well drafted. However, I would like to make a comparison to a specific product in commercial real estate and run the analysis over the same 5yr hold as a residential deal. If you are on board with the statement above, you place your bet on the income of your rental home increasing at the same rate as your taxes, insurance, and any other operating expenses. You beleive your tax assessor will not increase property taxes annually more than your rental income and you will never have a bad tenant (late pay, no pay, damage sheet rock, damage carpet, damage landscaping, etc). You also beleive your tenant will never leave, you will never have a down month, and you will not have to pay a real estate agent to lease the home for you.

Let’s say you buy a small Retail building with one tenant like a cell phone provider who signed a 10yr absolute net lease. The tenant will pay a specific amount monthly called “base rent”. In addition to this “base rent”, the tenant pays for ALL of the operating expenses to run the property, ALL of the property insurance, and ALL of the property taxes. They signed a 10yr lease and financially are worth hundreds of millions more than the tenant renting a rental home. If the toilet breaks, the retail tenant fixes the toilet. AND in most cases the retail tenant will pay moderate administrative fees to cover your property management fee. The rent is wired to your bank account on the 25th of every month.

If any of the expenses above increase, your tenant will pay for it. In my opinion, this is another example of a hedge against inflation. You are placing your bet on the credit of the tenant and reducing your exposure to inflation.

There is risk to ALL investments. Your rental tenant might never leave and pay any rental increases to keep the pace with inflation while my tenant files chapter 11. The most important aspects to any real estate investment are to understand your exposure to loss and create an investment return to meet your equity/cash flow objectives.

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Ali December 30, 2012 at 7:41 pm

Great comment, Nick! I really appreciated reading this. Commercial real estate is not something I’ve personally gotten involved with yet, so I really like that you made these points as I believe they are valid and worth consideration for all investors and for myself as I move along in my investing career. You’re right, every investment has a risk, and the most important thing to do is always analyze a deal and the associated aspects as much as possible (although don’t analyze to death or the deal will be out the window), and at the end of the day, do something smart. Yes, real estate as a hedge against inflation definitely includes commercial real estate. Thanks for adding that perspective!

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kyle hipp December 30, 2012 at 7:58 am

I think one interestong point is that rental prices make up roughly 40% of the inflation numbers that we see. So for the real estate market, inflation is not based on that new $400,000 house that was built but rather what that house could possibly rent for regardless if it will every be rented or not.

I believe that we will continue to see rental rates rise. I think property values will stay relatively flat. The supply of homes is muted and demand will rise with population growth. As unemployment falls a surge of supply can unleash but also a surge of untapped supply will be freed up to fill the need without much rate change.

I think Nick nailed it when he zaid make sure you property cashflows. The property value doesn’t matter too much if you are cashflowing….

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Ali December 30, 2012 at 7:44 pm

Thanks, Kyle. You’re absolutely right. If a property isn’t cash flowing, you are working with the wrong property. All decisions should be made with the idea that no appreciation will happen at all, and then if it does, it’s really just a bonus. And more than that, the property value only matters if you are buying or selling anyway, so as long as you have nice cash flow, value is irrelevant unless you are trying to get rid of it, but why even do that if it’s cash flowing. Great points :)

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Karen Rittenhouse December 30, 2012 at 11:21 am

Ali: I believe that the Fiscal Cliff is going to be more like a Fiscal Slope – though the term is not nearly so sexy for the pundits.

I LOVE real estate investing and it has been VERY good to me, even during the past 7 year downhill slide. There are so many ways to make a profit through owning real estate that I’m confused why everyone doesn’t do it!

Fiscal Cliff, boom, bust, or flatline, I am excited as heck to be investing in real estate and I plant to majorly kick up my investments in 2013. The Fiscal Cliff is not driving me anywhere – I focus on my own micro-economy. As I’ve been saying for the past 8 years, “There’s never been a better time to be in real estate!”

Thanks for your article.

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Ali December 30, 2012 at 7:50 pm

Here, here!! How could anyone not be totally pumped about real estate after that comment, Karen! I love when people are passionate about what they are doing. It makes for a lot more fun in life. You are right, boom or bust, real estate is awesome. It can be tailored in so many ways that no matter what the current economic situation, money can end up in your pocket. Like in the 1980s when interest rates were 15%+…if that were to happen now, so many people would freak and swear there was no way to make money in REI, but you know as good as I do, it’s all about tailoring to the situation. So much flexibility and all it takes is some fun creative juices to make it work. I personally could care less about the Fiscal Cliff nonsense myself. I like your term, “my own micro-economy”. As long as you keep sole focus on your own economy, you can make it no matter what the government is doing.

Your comment was so motivating I want to go out and find a new deal right now. Take THAT, Fiscal Cliff! ;)

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Robert Steele December 30, 2012 at 3:14 pm

All other things being equal, and @Dennis makes a great point about interest rates driving property values more than inflation, your property will be worth exactly the same in nominal terms today as it was 10 years ago. Inflation has not put $89K in your pocket. Inflation is the thief in the night – it is a stealth tax.

Consider that $100K property you purchased 10 years ago and now sold for $180K. If the appreciation was solely due to inflation then your net real profit is zero – BUT – the IRS is conveniently blind to inflation so you pay taxes on that phantom profit. End result is that you actually lost wealth!

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Ali December 30, 2012 at 7:54 pm

Robert, I can’t say I agree completely with the idea that you have lost wealth, but yes you are correct that if appreciation happens at the exact same rate as inflation, you are at a zero net profit. Luckily it doesn’t really work that way, but if it did, at least you have kept up with inflation with real estate whereas with most other investments you will not have kept up. This article or any of it’s points are not to suggest that there is a way to completely beat inflation, but rather the goal is to fight inflation in the best way possible. Most other investments outside of real estate and commodities, that I know of, don’t fight inflation well.

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Tim Czarkowski December 31, 2012 at 2:47 pm

However, that is only the case if you purchased the property with cash. If you used long term fixed rate debt you will come out ahead because the value of the debt has decreased while the value of the asset has increased. I consider real estate bought with long term fixed rate debt to be the best inflation hedge out there. As others have said make sure you’re going to cashflow and I personally just consider appreciation to be a bonus and do not factor it into my returns when analyzing properties.

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Jose Gonzalez December 30, 2012 at 6:49 pm

Ali,
Really great point of taking inflation as one of the best things to consider when investing in RE. Actually it is my second mayor variable.. since the first is cash flow and the strength it makes when added in volume.
Really I have seen many huge investors that own properties, buildings, houses or whatever piece of land that in the real long term, it is ridiculously appreciated and in most cases much higher than inflation applied to commodities and luxury items.
I really enjoy reading your articles and look foward to see the next one!
Thank you!

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Ali December 30, 2012 at 7:58 pm

Thanks, Jose! I really appreciate the feedback. I look forward to writing more and I’m excited to know someone will read it ;) You’re right… it is not uncommon for the appreciation of a property to well surpass inflation, much more than commodities or other investments. There are other variables associated with the whole idea of course, that I notably left out of this article, and those can be argued, but the fact is if anything can beat inflation, real estate is certainly in the running for that crown. And yes, what ultimately matters is cash flow so whether a property appreciates or not is irrelevant, but it is definitely nice when the appreciation zooms past inflation. Thanks again for sharing!

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Michael January 1, 2013 at 7:56 am

Hello Ali,

I like the simplified definition . I look at cash flow as king and appreciation as a bonus as you do! tough to lose that way.

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Ali January 2, 2013 at 12:22 pm

You know it, Mike! I love not losing :)

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