Are Note Investments Safe From Inflation Risk?

Question

Anyone else getting this question a lot lately?

When we buy notes at a discount our return far surpasses the rate of inflation. In 2020 the average rate of inflation was 1.2%. In the past 20 years the annual average has stayed under 4%.  If you are buying notes with an IRR of 8-12% you are pretty protected from inflation risk on your portfolio.  While inflation could be on the rise, it is a far reach from surpassing the returns from note investing. You have to go back to the early 80’s to see inflation hit 10%.

Would like to get your input on how you like to answer the inflation question.

Ned Carey · Answer

@Tracy Z. Rewey inflation usually leads to or results from higher interest rates. The value of your note could decline if you want to sell it. My guess is that is not an issue for most here as I get the impression is it is all about the cash flow. You also have the potential risk of opportunity cost.

But I really like @Jamie Bateman's point about the underlying asset securing the loan is more valuable.  But then again opportunity cost is always a risk.

Jamie Bateman · Answer

Good topic and good points. I also like to point out that if you are buying mortgage notes, your collateral position is likely stronger with an uptick in inflation. Real estate can be a strong hedge against inflation.

Chris Seveney · Answer

From a financial side yes inflation would have an impact as treasury bills increase and there are many investors who look for a risk free rate (investment yield minus treasury rate).

If an investor looks for a 7% RIsk free rate of return and tbills go up to 4% from say 1% lately then they will look for a 11% from a prior 8% on that asset. Thus lowering the value of your asset

Zachary Beach · Answer

@Tracy Z. Rewey the CPI is a very misleading number and the actual rate of inflation is higher arguably much higher before the extra money printing of COVID it was closer to 6-12% than 2% the government states. Now who knows how high it will go.

Zachary Beach · Answer

@Tracy Z. Rewey good questions I think that there are a few things at play. I think that the main thing is just that if you are getting note returns of say 12% your wealth is not substantially increasing as much as you think with stated inflation your buying power would be doubling every 7 years. If the inflation rate is really 6% than your buying power would only be Doubling every 12 years if it’s really say 10% than it’s only doubling every 36 year. It’s also important to consider how much money was put into the economy this year because at least for assets there has been well over 10% inflation probably closer to 20+% this year looking at stocks and real estate. Both markets I own real estate in have had over 20% appreciation this year and I see that staying decently high in the upcoming year. I think that the current economy system is not ideal for note investing because the interest rate will stay low because of stated low inflation but that the real rate of inflation will eat away most of the spread. Don’t get me wrong I think it’s a better opinion than may things I just think there are higher returning option. Form a pure cashflow stand point there are not that many better options as most LTR’s under properties management would have lower cashflow and most STR mangers are not great  at making top profit. The STR properties we manage make a similar CoC return to the 10-12% you stated after management if they are owned free and clear and bought at current market value. plus also have the tax benefits, appreciation and if mortgaged the leverage benefits also. Plus are a hedge for inflation. The type of deals I advise people on have expected IRR’s over 30% a year with 0% appreciation. All my STR properties had over 100% return on equity this year largely because of appreciation but they have high returns without appreciation also. I suggest getting as much long term low interest fixed rate debt as you can on properties that cashflow and have appreciation potential.

Tracy Z. Rewey · Answer

@Zachary Beach Interesting read and thanks for sharing.  Curious your thoughts on how  the understated inflation will impact a note portfolio?  We have bought and sold notes since 1988 so have seen many economies.  I've found that interest rates, real estate appreciation, and the economy as a whole impact prices more than inflation.  Although it could be argued those items also impact the true rate of inflation. Thoughts?

Zachary Beach · Answer

@Tracy Z. Rewey I attached an article from Forbes and a YouTube video from a guy I watch sometimes that has lots of great stuff. He uses shadow stats I believe and I have looked at another index in the past I can remember the name of and can’t seem to find. Basically the government changed how they calculate inflation to make the inflation rate seem lower. They have many reasons showing lower than real inflation is helpful to the government. 1 it makes it seem like the economy and the politicians are doing better than they are.  2 It also means they can borrow money, bonds at a lower rate. 3 they increase social security and government pension based on inflation so if the inflation rate is lower it save billions by this points trillions of dollars. In fact if you take the way the government calculated inflation in the 1970’s for the last 20 years and adjusted social security benefits based on the old number compared to the new one the government would have to be playing over twice as much in benefits. 4 tax brackets are adjusted by inflation so if the number is lower than the real rate it is a increase of taxes on the entire economy. 5 it increases trust in the dollar. The only thing giving the dollars value is our belief in it  the more we believe it retains value the more we believe in it.

I have personally maked hundred of thousand last year alone betting on inflation and I’m going to keep betting on inflation as it’s the only way the government can stay ahead of its debt.

I have a Short term rental business for properties I own as well as managing for others and my market has seen a 58% increase in STR rents in one year my particular properties are up 63% the stock and real estate markets are up at all time highs even after last year being the worst year for GDP compared to the year before in the US since 1946. The reason? Look at the insane increase in the Money supply. Also look at how low the rate of earnings to stock price and long term rents to real estate are. There is much more even than what I have said but I’m not trying to write a book right now.

https://youtu.be/SIh7SKj05po

https://www.forbes.com/sites/perianneboring/2014/02/03/if-you-want-to-know-the-real-rate-of-inflation-dont-bother-with-the-cpi/

Tracy Z. Rewey · Answer

The increases in real estate definitely support that!  What index or site do you like to use to track inflation?

Jamie Bateman · Answer

@Tracy Z. Rewey, yes. We started in the rental space and now have a portfolio of SFRs in MD and a growing # of rentals in your state of FL. Our rental in Jacksonville we acquired through an NPL (not the intent at the outset), and we are buying a build-to-rent in Ocala.

Tracy Z. Rewey · Answer

@Jamie Bateman Great addition.  As real estate prices go up the value of the collateral goes up giving our payor's more equity to protect.  I'm curious, do you balance your portfolio with real estate along with real estate notes?

@Ned Carey Yes, definitely agree.  Higher interest rates can lead to a higher cost of funds.  When rates are low, notes can be sold on the secondary market for higher prices.  We recently sold an existing 0% note (trust me we didn't write it at that rate - it came to us that way) to an institutional investor at a 4% yield because their cost of funds would allow them to buy at that rate.  That same 0% face rate note would have dropped in value by almost half if the required yield would have been higher (say 8%).

When we are marketing for notes we let the holder know that right now their future payments are worth more since rates have never been lower.  Just like locking in a low rate mortgage loan, the pricing on notes changes as interest rates rise.

If you buy notes using credit lines you also have to be sensitive to changing rates, especially when notes are long term (20-30 years - and what incentive is there to payoff a 0% real estate loan unless you sell the property?)  As you mentioned, usually there is enough cash flow and yield spread to act as a cushion but an important factor for certain.

Are Note Investments Safe From Inflation Risk?

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