Deflation, Stagflation, Inflation, Hyperinflation and Uncertainty
Investor · Mountain View, CA · Member since 2013 · 94 posts · 42 votes
I've read a lot about having a three legged stool approach as a way to preserve and grow wealth involving a hedge for
It would seem to me that we have two additional possibilities on our horizon due to our federal debt levels:
Are you starting to hedge for stagflation or hyper-inflation?
The United States government has a $18 trillion deficit not included infunded liabilities. Those that think the US dollar is not are risk are not doing simple math. In the short run, the bigger problems in the world are in Europe and Japan, but in the long run the dollar will be at risk as well.
In your scenario, I think inflation is the least likely. During the Reagon/Volcker days of 20% interest rates created by Volcker to fight inflation, we didn't have an $18 trillion national debt. If the US treasury had to pay 20% interest in $18 trillion, the interest payment of $3.6 trillion would exceed all tax revenues. I believe we won't see interest rates this high as the government will keep running manipulated low interest rates until it causes a bubble so big that it will explode.
Understanding the state of these perpetual Bubble economies, a long term buy and hold strategy makes no sense. The roller coaster ride will only have higher highs and lower lows as we are in a state of long term low interest rates. I am a "buy and hold a while" investor. Since 2009, I have personally (outside of the hedge funds I run) been buying 10 rental properties a year at an average IRR of 70%.
Between 2009 to 2011, you could get 24% cash-on-cash newly constructed for $80,000 in Phoenix and that market has appreciated up to $280,000 today. The rents have gone up by $500/month. Those turnkey buys bought during those years are 80%+ IRR. Between 2012 and 2013, I was finding 2% rule deals in class B neighborhoods in Memphis, Houston, Kansas City and Birmingham. I realize my IRR had dropped to less than 30% and so in 2014 till today I started buying 65% IRR BRR deals locally in Tacoma where I get an instant equity of 30% and then 1.25% to 1.5% rule cash flow deals. 40% of these deals are R2 lots over 14,000 sq ft that I subdivided and build a new house to rent.
Real estate historically tends to go in major crashes around every 18 years (15 to 20 years) unless we run into a world war or a currency crisis. The last crash was in 2007 and according this theory real estate would crash around 2025 with 2022 being the early side of it. The next global meltdown I believe will be much worse than 2008 and more like the 1929 crash. England and Germany were the safeguards of the European Union and now with Brexit the next crash will be caused by a sovereign debt crisis in either Portgual, Italty, Ireland, Greece or Spain. Brexit has set a precedent for one of these five countries to leave the European Union to deal with their sovereign debt crisis. One of these five countries will do something similar to what Germany did in 1921 where they ran the printing press on marks to stimulate the German economy through cheap exports. The financial experiment worked and by 1924 Germany because a major industrial power. Although we cannot forget the emotional trauma of wheeling barrows of marks to buy a loaf of bread. The Germans went through so much emotional turmoil during hyperinflation that it set-up the psychology for Hitler and also for getting revenge on the Jewish Rothchild bankers who they perceived as the cause of their problems.
England followed suit after Germany and devalued their currency and cheap exports being dumped forced the US and the rest of the world to put up Smoot-Harley tariffs. Printing currency recklessly always results in the same outcome... Trade wars and then a breakdown in global trade. I am betting that the prices of those Phoenix houses will pass $400,000 and during the next 2025 global meltdown will tumble all the way back down below $80,000 again.
So around 2020 or 2021 (will watch the world markets and see what is going on), I will sell all of my buy and hold rentals and probably donate 100% of the profits into my 501(c)3 non-profit start with America.
1) I don't buy cash flow properties to get out of the rat race so my passive income exceeds my expenses. I buy cash flow properties and don't touch the cash flow. I use the cash flow pay down the debt. The best hedge against deflation and hyper-inflation is cash flow rentals owned free and clear.
We are going to have low interest rates for a long time and it will make the bubble crazy crazy big. Deflation happens when the bubble pops. Recent financial experiments in Japan show that they cannot stop deflation no matter how much money they print. You can print all the money but you cannot force people to spend it. Interestingly, I think the money does get back into the economy through hedge funds. When the real estate hits a equilibrium where it is cheaper to buy properties than the replacement cost to build them, the hedge funds come in and get capital under 2% and buy whatever they can get. Hedge funds are the new way to stop deflation from spiraling forever and that is why I think running a hedge fund is the best way to invest in real estate.
2) Quantative easing causes exports to be cheaper and too much quantitative easing by multiple countries will lead to a breakdown in global trade. The hyper flatiron is created on purpose by a government that can't pay the interest on its debts. Governments will never pay the interests on their debt if they can't afford. They always will opt for hyperinflation, get exports cheaper and screw their people for 2-3 years. The people will be so emotionally worn out that they will do something like geneocide and will be willing to fight a world war.
When a government cannot pay the interest on their debt, they will manipulate interest rates as long as they can until they have no choice but to create hyperinflation.
3) During deflation, debt becomes burdensome. During hyperinflation, debt is like free money. The problem that deflation and hyperinflation are so closely linked, you need a strategy that covers both. And that is buy your cash flow rentals and use the cash flow to pay down the debt.
The United States government has a $18 trillion deficit not included unfunded liabilities. Those that think the US dollar is not are risk are not doing simple math. In the short run, the bigger problems in the world are in Europe and Japan, but in the long run the dollar will be at risk as well.
In your scenario, I think inflation is the least likely. During the Reagon/Volcker days of 20% interest rates created by Volcker to fight inflation, we didn't have an $18 trillion national debt. If the US treasury had to pay 20% interest in $18 trillion, the interest payment of $3.6 trillion would exceed all tax revenues. I believe we won't see interest rates this high as the government will keep running manipulated low interest rates until it causes a bubble so big that it will explode.
Understanding the state of these perpetual Bubble economies, a long term buy and hold strategy makes no sense. The roller coaster ride will only have higher highs and lower lows as we are in a state of long term low interest rates. I am a "buy and hold a while" investor. Since 2009, I have personally (outside of the hedge funds I run) been buying 10 rental properties a year at an average IRR of 70%.
Between 2009 to 2011, you could get 24% cash-on-cash newly constructed for $80,000 in Phoenix and that market has appreciated up to $280,000 today. The rents have gone up by $500/month. Those turnkey buys bought during those years are 80%+ IRR. Between 2012 and 2013, I was finding 2% rule deals in class B neighborhoods in Memphis, Houston, Kansas City and Birmingham. I realize my IRR had dropped to less than 30% and so in 2014 till today I started buying 65% IRR BRR deals locally in Tacoma where I get an instant equity of 30% and then 1.25% to 1.5% rule cash flow deals. 40% of these deals are R2 lots over 14,000 sq ft that I subdivided and build a new house to rent.
Real estate historically tends to go in major crashes around every 18 years (15 to 20 years) unless we run into a world war or a currency crisis. The last crash was in 2007 and according this theory real estate would crash around 2025 with 2022 being the early side of it. The next global meltdown I believe will be much worse than 2008 and more like the 1929 crash. England and Germany were the safeguards of the European Union and now with Brexit the next crash will be caused by a sovereign debt crisis in either Portgual, Italty, Ireland, Greece or Spain. Brexit has set a precedent for one of these five countries to leave the European Union to deal with their sovereign debt crisis. One of these five countries will do something similar to what Germany did in 1921 where they ran the printing press on marks to stimulate the German economy through cheap exports. The financial experiment worked and by 1924 Germany because a major industrial power. Although we cannot forget the emotional trauma of wheeling barrows of marks to buy a loaf of bread. The Germans went through so much emotional turmoil during hyperinflation that it set-up the psychology for Hitler and also for getting revenge on the Jewish Rothchild bankers who they perceived as the cause of their problems.
England followed suit after Germany and devalued their currency and cheap exports being dumped forced the US and the rest of the world to put up Smoot-Harley tariffs. Printing currency recklessly always results in the same outcome... Trade wars and then a breakdown in global trade. I am betting that the prices of those Phoenix houses will pass $400,000 and during the next 2025 global meltdown will tumble all the way back down below $80,000 again.
So around 2020 or 2021 (will watch the world markets and see what is going on), I will sell all of my buy and hold rentals and probably donate 100% of the profits into my 501(c)3 non-profit start with America.
1) I don't buy cash flow properties to get out of the rat race so my passive income exceeds my expenses. I buy cash flow properties and don't touch the cash flow. I use the cash flow pay down the debt. The best hedge against deflation and hyper-inflation is cash flow rentals owned free and clear.
We are going to have low interest rates for a long time and it will make the bubble crazy crazy big. Deflation happens when the bubble pops. Recent financial experiments in Japan show that they cannot stop deflation no matter how much money they print. You can print all the money but you cannot force people to spend it. Interestingly, I think the money does get back into the economy through hedge funds. When the real estate hits a equilibrium where it is cheaper to buy properties than the replacement cost to build them, the hedge funds come in and get capital under 2% and buy whatever they can get. Hedge funds are the new way to stop deflation from spiraling forever and that is why I think running a hedge fund is the best way to invest in real estate.
2) Quantative easing causes exports to be cheaper and too much quantitative easing by multiple countries will lead to a breakdown in global trade. The hyper flatiron is created on purpose by a government that can't pay the interest on its debts. Governments will never pay the interests on their debt if they can't afford. They always will opt for hyperinflation, get exports cheaper and screw their people for 2-3 years. The people will be so emotionally worn out that they will do something like geneocide and will be willing to fight a world war.
When a government cannot pay the interest on their debt, they will manipulate interest rates as long as they can until they have no choice but to create hyperinflation.
3) During deflation, debt becomes burdensome. During hyperinflation, debt is like free money. The problem that deflation and hyperinflation are so closely linked, you need a strategy that covers both. And that is buy your cash flow rentals and use the cash flow to pay down the debt.
Hi Ryland,
Your write up/response is spot on! Very thorough and well though out.
Natasha you pose a great question throughout this thread that is maybe even a better thought experiment. As someone who studies macro economics extensively, I can tell you that no one can predict anything beyond a flip of a coin. That includes PHD economists and everyone on BP (including myself). Why? Because the world has simply never seen this before. 40% of the sovereign debt in the world is being issued at NEGATIVE interest rates. This alone should be enough to open everyones eye's to the instability and unpredictability we're currently facing.
In an effort to help you better understand the environment, and therefore come to your own conclusions (hedges), I'll lay out an argument and counter argument for each scenario... Deflation, Stagflation, Inflation and Hyperinflation. *PLEASE NOTE: "Stagflation" is high inflation with high unemployment and shrinking demand (think US in the 1970's). Japan hasn't had stagflation in the past 25+ years, if anything, it's been more stagnation, which is what I'm guessing you meant but I'll address both.
Additionally, I'll include components of behavioral economics and charts to better assist you in your decision making. And before moving on, I'd like to define two things: Money supply and velocity of money. Money supply is the amount of money that exits, for this post I'll include credit in money supply because credit, to a certain extent, is purchasing power. The velocity of money is how quickly money moves throughout the economy.
DEFLATION, INFLATION, HYPERINFLATION, STAGFLATION AND THE ARGUMENTS
DEFLATION: Deflation, when prices in the overall economy decrease, is most often created by a reduction in spending. This reduction of spending can be a result of less money (credit) in the system or a result of the velocity of money slowing down. When the amount of credit exceeds the levels of income debts can't be paid back and credit contracts. Since credit is purchasing power, when it contracts it creates less spending and lower prices. NOTE: Deflation can also be a result of increased productivity and technology, which is very healthy, but unfortunately that's not the deflation that's applicable to our macro economy today.
Since the early 1980's interest rates have gradually gone down. From almost 20% to today at almost 0% and in some countries negative. Lower interest rates reduce monthly debt payments which allows increased spending without an increase in income. This is why debts, individual and government, have soared in relation to "real" income (adjusted for inflation) and GDP.
One strong argument for deflation is credit, whether public or private, has got to the point were the incomes or GDP can't pay them back. This would create less credit, a slower velocity of money, less spending...deflation.
Another strong argument for deflation is the velocity of money decreasing because of additional regulations and uncertainty. As an example, in 2009 businesses and individuals stopped spending and increased savings due to uncertainty. The individual spending has picked back up but business spending is still slow. Some would say this is a result of increased regulations, others would say it's due to the macro economic environment. It's tough for large business to invest in hiring and R&D when the global economy is so crazy borrowers are being paid to borrow (negative interest rates). The slower velocity, again, creates less spending and deflation.
INFLATION: The proper definition of inflation is an increase in the supply of money. The result of inflation is usually price inflation, which is the more poplar definition. Price inflation occurs when the supply of money increases at a rate faster than the rate of goods and services or when the velocity of money increases. With more money chasing the same amount of goods and services overall prices rise.
A strong argument for inflation is the fact the the supply of money has increased dramatically since 2009. "Quantitative Easing" is a fancy way to say printing additional money. Lower interest rates increase the amount of credit in the system (to a certain point) and the more credit in the system the greater the supply of money.
Based on the level of increase in the supply of money since 2009 we should've seen massive consumer price inflation. Why haven't we? Because the velocity of money has decreased as well. If trillions of additional dollars are created and then placed in a vault somewhere, those dollars won't get into the economy to create inflation. Where has all the money gone that's been created since 2009? Financial assets...stocks, bonds, real estate, art etc. If the fed continues to keep rates low, and theres several reasons they will, increases money printing, at some point that money will flow into the economy. And if the velocity of money increases consumer price inflation would sky rocket. One could argue that the fed could just increase interest rates to slow inflation but that would be incredibly difficult because private and public sector debt would become more expensive creating a recession if not depression.
Another strong argument for inflation is that it helps debtors. As we all know, in terms of total nominal amount, the government is the largest debtor in history. The only way for them to reduce their debt burden is to increase inflation. Knowing that they'll pressure the fed to do everything in their power to create price inflation it's easy to believe they'll achieve the objective. I personally feel the rate of inflation is understated purposely to give the fed an excuse to keep rates low. This increases nominal GDP which increases tax receipts without a need for increased productivity or real income growth. I'm sure you've heard the term "don't fight the fed", if you lean towards the inflation scenario your on the same side as the fed (and the government)...usually that's a good bet.
HYPERINFLATION: Unfortunately theres no precise definition for hyperinflation. When we think of the term we immediately reference Germany, Zimbabwe, and more recently Venezuela. While these examples are definitely applicable I'd propose they're extreme cases and hyperinflation can easily be defined as what the US experienced in the 1970's when consumer prices doubled and tripled in the span of just a few years. Most don't recall but inflation in the US was so bad we had to issue bonds in currencies other than the dollar (called "Carter bonds"). If you suggested this scenario today, I'm sure people would scoff at how impossible it would be for the world to have so little faith in the dollar the US government would have to issue debt in a foreign currency. But this happened within most of our lifetimes.
A strong argument for hyperinflation: As we discussed above americans and our government are incredibly indebted. If interest rates were to increase substantially the private sector and the government would have an incredibly difficult time making the debt payments. Another gentleman that posted showed how an increase in interest rates would create a scenario where the payment on the debt alone would exceed 100% of the tax revenue. Obviously the government/fed can't let that happen. They've backed themselves into a corner where they can't increase interest rates past a certain level without creating a disaster. Therefore if the velocity of money increases, and we see price inflation, the fed might not be able to raise interest rates high enough to combat the inflation. Individuals and governments that own dollars will see this and know the dollars they own are decreasing in value (purchasing power), creating a "hot potato" situation with dollars adding gas to the fire. If the fed didn't raise rates, because they can't increase the debt burden on individuals and government, "hyperinflation" could be the end result.
STAGFLATION: Again, stagflation is price inflation with high unemployment and low demand/spending translating to little or no real economic growth (adjusted for inflation). Prior to the 1970's economists thought this was impossible. It's still a black mark against the Keynesian school of economics, stagflation disproving many of their economic models.
A strong argument for stagflation is just look at the current US economy. Most of the data suggests that it's sluggish at best. The unemployment rate is low but the labor force participation rate is at 40+ year lows. What this means is that there's the same or fewer people working today than there was years ago, yet our population has increased. The unemployment rate really doesn't matter, what matters is the amount of people who are employed and can spend the money they earn relative to the overall population. If the unemployment rate is 4.9% but fewer people are actually earning money because fewer people are in the labor market, from a macro view, it has the same effect as high unemployment.
If you believe that the inflation rate is higher than the CPI put out by the government, then we're in mild stagflation now. To this I'd submit the way the government calculates CPI has changed many times since the 1970's...every time it resulted in the CPI being stated lower than before using the previous method of calculation.
I said I'd mention STAGNATION. This is basically low or no economic growth with low inflation or mild deflation (Japan). If you believe the current CPI numbers then you could argue we've been in economic stagnation for the last few years with the exception of assets which we discussed earlier. It's also plausible we'll continue in this state for many years to come.
*Side Note: Japan's printed staggering amounts of money and has a debt to GDP ratio north of 200% so why haven't they experienced inflation and can't we assume that the US will follow the same path? Maybe, but we need to remember the velocity of money. Due to culture and demographics the velocity of money has slowed faster than the BOJ (bank of japan) can print money. The US doesn't have the same demographic problems and our culture is oriented towards spending not saving. As a result, it's erroneous to assume the US is the next Japan...it may or may not be.
That's deflation, inflation, hyperinflation, stagflation in a nut shell and the arguments for each.
WHAT TO DO NEXT?
Obviously, each argument is a counter argument for the other. Now the question is what to do with the information and how can you use it to take actionable steps towards hedging.
What I do personally, is know that nothing is certain and there only probabilities. To which extent, you need to thoroughly understand, and know the facts, concerning the potential out comes and handicap or give a probability to each, based on your own logic and beliefs.
You already know that inflation favors holding debt and deflation favors holding cash. In a situation of overall price inflation or deflation the equity in your real estate portfolio theoretically doesn't gain or lose purchasing power. Which is why it's been suggested in previous posts equity is the ultimate hedge. I would caution though that this is only true if OVERALL prices are going up or down (including assets). It's possible, potentially even probable, to have asset prices go down with out overall consumer prices going down (i.e. 2009). If housing prices go down or don't rise at the rate of broad consumer prices your equity will lose purchasing power. There are several examples through out the last 115 years where housing prices have decreased in real terms "inflation adjusted." See chart below illustrating this between 1970 and 2014.
My point is twofold. First, when thinking about hedging, understand that there's a difference between overall consumer price deflation/inflation and asset price deflation/inflation, and they can occur independent of one another. Again, the last 7 years are great examples of this. Second, because consumer price inflation/deflation can be independent of asset inflation/deflation, the only way to hedge 100% of your portfolio is to have no equity and a 50/50 split of cash and debt. I'm by no means suggesting this or implying it's even possible, I'm only pointing it out as a theoretical matter of fact.
To summarize, I'd digest all the information, study the data and then access probabilities to each possible scenario, viewing it from the lens of your own beliefs. Once this is done use the probabilities to build a portfolio around your tolerance for risk, need for cash flow, capital appreciation or capital preservation. With all due respect, anyones opinion or how they're hedging should be taken with a grain of salt and that includes mine. No one knows whats going to happen beyond the flip of a coin and everyone's goals and risk tolerance is different. Therefore this should be a very individualized decision.
Below I'll include a youtube link to an animated, very easy to understand, presentation on how our economy works and why we have inflation and deflation in consumer prices and assets. It was done by Ray Dalio who runs the largest hedge fund in the word, Bridgewater. I'd suggest every real estate investor watch it several times. As promised I'll go into behavioral economics to assist you further in a different post because this one is already way too long. And I apologize in advance for typos, poor writing or incoherent thought...I'm at the end of a 3 day water fast so I'm a bit foggy. If you or anyone else would like further clarification please don't hesitate to ask.
I sincerely hope this helps you in your decision making process. Good luck.
@George Gammon Thank you for the well thought out analysis! If you can do that after 3 days without water, I can only imagine what you're able to do on a full tank. I like your suggestion of coming up with my own probabilities of different scenarios, and adjusting my hedges accordingly. A lot like trying to find a positive expected value solution for the economy. The challenge will be if I can come up with realistic probabilities! Ray Dalio's animation on how the economy works was helpful. I've seen it before, but I watched it again.
Glad I could help. BTW, 3 day fast with only water not without water... ;)
@George Gammon How are you positioning your portfolio based on your assessment of markets and economic conditions?
@George Gammon Oh good. Glad to hear water was included. Otherwise I'd have to relearn the basics on economics and the essentials for human life :)
Unlike many that post on BP I'm of the belief that I'm not smart enough or educated enough to predict anything.
The more you study and analyze macro the more you realize how little you know or how little can be known.
That said, I try to start with what is known. And that is the world economy (including the US) is incredibly fragile and potentially volatile.
Because the economy is so tenuous I position my portfolio as conservatively as possible. I like an equivilant amount of cash and debt. I do have a lot of equity but all my US equity was purchased in 2012, distressed, and with cash. Therefore I've got 50% of downside cusion before my principle is at risk.
Many on BP promote buying now but some markets are at 2007 levels. If they buy with a 20% down payment and the market drops 30% they're wiped out. These promoters of "buy now, buy always" think that the market will always go back to a high water mark. So if your property cash flows you're at no risk because even if the market goes down it will eventually come back. This is weak thinking because prices have out paced incomes exponentially (see deleverage in Dalio's video). If the market goes down 30% it's very possible it won't recover until prices match incomes (as they did between the year 1900 and 2000). This could take decades. Remember, the market hasn't "recovered" it's re inflated.
Also, they forget about the opportunity cost of not having cash if markets decline.
That's not to say the market will drop. The fed could take rates negative and do more QE which would potentially drive asset prices further. I'm only saying if you buy today your downside risk is substantial because prices are so much higher than their historic trend line. (Unless you can buy at 2010-2012 prices.)
Return always has to be adjusted for risk...
Hope that helps Mike.
@George Gammon But this time is different.....
@Bob E. @Natasha Keck @Mike Dymski
Natasha I pulled this chart from the St. Louis fed's website because it pertained to your market. The difference in historic trend line and price is potential downside.
And Bob, to your point, I'd be interested in how someone bullish would assess risk in the SF market based on this chart (inflation adjusted), comparing todays prices to 2007 prices? It may be "different this time" but prices are the same. ;)
@George Gammon To be honest I am not all that sure what to make of your chart - I am looking at CoC returns as being more relevant. In Phoenix we are seeing a lot of 7% cap rates with deferred maintenance that are not in great parts of town.
To me that is a warning sign.
@Natasha Keck @Mike Dymski @Bob E.
Natasha, as promised, here's some behavioral econ stuff. I cut and paste from other writing I did today on a different topic so hopefully it makes sense. I think if you read this from the position of trying to understand the current market participants (investors, buyers, sellers) it'll help you better handicap probabilities of prices going up or down in your market. Participants have been conditioned by the market they have experience with...the same way Pavlov conditioned his dogs, markets condition us.
When ever I hear "experts" in the field of investing, be it stocks, bonds, real estate etc. , I'm always cautious. I think in order to assess their opinions, first one must understand the framework of their experience. It's something totally overlooked by the media, the interviewers of the "experts", the people listening and, most likely, the "experts" themselves.
We've all heard on CNBC, podcasts, blogs etc. "I think the markets hot and you should buy this dip", "I think the markets overheated and it's time to sell", or something I heard the other day which blew me away "I think you should buy real estate now, at the top of a bubble, at the bottom of a bubble...It's never a bad time to buy real estate."
Let's use the last quote as an example analysis, first understanding the framework of the "experts" experience. This person started investing in real estate in 2008. The only thing they've ever experienced is prices going up and interest rates going down. Granted they saw the housing crash in 2007, but at the time, they were a real estate agent, not an investor.
It's been shown numerous times that humans can watch something happen countless times and it rarely effects their behavior but if something actually does happen to them, it will effect their behavior intensely.
Insert Isaac Pavlov... we all know the story of Pavlovs dogs and the Pavlovian response. What we forget is that we humans get conditioned as well. Investors even more so, because their conditioning is ingrained by having money on the line, which is extremely powerful. Like Pavlovs dogs salivating by just hearing a bell ring, investors who have only experienced a bull market or lower interest rates are subconsciously conditioned to have a long bias. They rationalize this bias so consciously, they think it's correct based on the data, when in actuality they're cherry picking data that confirms what their sub conscious is telling them. If something happens contrary to their thesis the magic of cognitive dissonance kicks in.
I've studied countless successful investors that have had money on the line in bull markets, bear markets, lower interest rates, high interest rates and everything in between. One thing they all have in common is the ability to question themselves, their thinking and opinions objectively. And they're all able to change their thinking, opinions or investments on a dime. They all display a humility when analyzing markets. I've noticed the smartest investors in the world are always the one's that never hesitate to say "I don't know" or "it's impossible to predict." Because of this insightful humility they're always focused on risk management first and investing second. They have an uncanny ability to be introspective, understand their own sub conscious bias, and account for it when making decisions.
The average investor or "expert" is the complete opposite. If they analyze risk at all, it's 1% of their decision making. The other 99% is selecting the investment. They never look at themselves introspectively and objectively. They have no idea what they've been conditioned for, let alone taking it into consideration when forming an opinion on an investment thesis.
I'd like you to take the following away from this post:
1. When watching TV, listening to a podcast or reading a blog always look at the opinions being given through the lens of the interviewee's experience and how their experience most likely conditioned them. Most don't have the self awareness to layer their own bias over their thesis, so you need to do this when disseminating the information or opinions being given.
2. Always analyze risk first. If it's completely unknowable, move on to the next investment opportunity.
3. Remember only looking at ROI is a fools game. Risk adjusted return is all you should concern yourself with.
4. That said, the more an "expert" talks about managing risk and the less they talk about return the more of an "expert" they most likely are. And vise versa...
@George Gammon To be honest I am not all that sure what to make of your chart - I am looking at CoC returns as being more relevant. In Phoenix we are seeing a lot of 7% cap rates with deferred maintenance that are not in great parts of town.
To me that is a warning sign.
The chart shows that prices in the San Francisco market are at the same levels (or higher) than the were in 2007. I don't think any investor wouldn't admit that in 2007 the market was in a bubble. Therefore, arguing that the current market is not in a bubble (like many SF investors have) is inconsistent at best.
@George Gammon I would concur that the risk on the downside for the San Francisco Bay Area market is far more likely, and much larger than the potential upside right now. I would also agree that everyone brings their own lens to the world (and economics) which colors their behavior and advice. I guess I had looked for the lens in social settings, but not elsewhere. Do you have any tips for how a newbie might "analyze risk first"?
@Russell Brazil I really like your comment above "I plan to lock in as much debt as I can for as long of periods as I can." I have to say this blew my mind when I heard you say it on a BP podcast, but you're so right! Interest rates are crazy low. Like Natasha, I've been sitting on the sidelines waiting for a deal that meets ALL of my criteria and I, too, am nervous about the economy. But your philosophy has been a game changer. I'm now comfortable relaxing some of my metrics in order to get into a property because it's doubtful we'll see lower interest rates any time in the next couple of decades. I'm not saying we're going to make bad deals, but, for example, maybe being satisfied with 8% profit on a flip instead of 10% in order to buy now. Or a 7.5% cap rate on a multi family instead of 8-10%. I'm more afraid of having money sitting in the bank if there truly is a big blow to the economy than I am of having it sitting in tangible real estate assets. So thanks for the perspective.
@Natasha Keck, I am agree with you that investing in California is higher risk. Already too much appreciation that there is no affordability for tenant. Economy is too much Tech dependent and i am expecting Tech is already in Bubble.
I must be partial here but Still market is good in Texas. I am not saying not great like few years back.. but still good and i am not sure how long it will take for GREAT again... I am happy with good deal for now.
The FED will keep rates low for years to come. They have painted themselves into a corner. One of their concerns is asset prices. Low yields force people wanting returns to invest in equities and real estate. The FED wants high asset prices. The other main concern for the FED is the interest they pay on the debt. They are borrowing money to pay interest. The FED is recently even discussing negative rates. Don't be surprised if we go that route. As to investing, I am a firm believer in buy and hold. I also do private lending which yields excellent returns. I am a firm believer in being safely leveraged and not going overboard. When the markets cycle, investors that have reserves and don't owe 90% on their properties will survive. There will always be winners and losers in RE. Plan ahead to make sure you are in the right group.
@John Thedford I agree strong reserves and low LTV (or truly your cash flow) will decide who survives. 90 LTV is lunacy. What kind of LTVs do you feel is safely leveraged?
I am very lightly leveraged. Each investor has their comfort level as well as external factors that lead to their decision. I can quit any day. If I was 30 years younger I would take a different approach. If you have the ability to pay off debt, having more leverage may not be an issue. Little cash, few reserves, and high leverage can mean big trouble when the market turns.
Wow, Natasha. What a thread. Thanks for including my 3-legged stool article to get it all started. Jack Miller, a now deceased investor and teacher coined the concept. He was great.
I certainly can't quote macroeconomics, hedge-fund strategies, or international currency statistics like some of the others have. But they were interesting to read!
Like some of the posters, I fall into the "can't predict the future" camp. I do the best I can to study my local trends (jobs, incomes, housing inventories, construction prices, etc), and then buy deals with solid current fundamentals (yield > expenses, no risky debt, potential upside from adding value).
Lately we've invested a lot of cash with some debt (about 50-60% LTV in most cases) because we've found deals in our market with good yields. The deals were not obvious, though. We bought value-add multiunit deals in good locations that eventually cap out at 8-10%. They start at 4-6% when we buy them. Rents have gone up locally because of increasing student populations, so there have been pockets of these opportunities where old landlords keep their rents too low and we can raise them. We've also found some sellers open to long-term, low interest financing at 4%. That's a winner.
In the big picture, if we can get 7-10% cap deals with non-balloon debt at 4-5%, we'll keep doing it. Natasha, unless you can get mortgage debt cheaper than that, I would be nervous about local yields too. Maybe look elsewhere?
But a lot of what I've read here so far sounds like people with BIG hedge-fund type money to invest. For us little investors, it also matters thinking about your personal phase of life. If my portfolio and passive income is enough to pay for my lifestyle using free and clear 6% yields, that's a pretty good place to be. Just keep risk low, set aside plenty of cash, own in solid locations, and enjoy your life.
It's the people who have to constantly grow and chase yields that need to worry the most about all of this. I wouldn't envy you hedge fund managers for anything. Lol. But I do appreciate your insights!
@Chad Carson Thanks for reading my post! I have learned a ton from your posts and blog. Good stuff. I keep waffling between aiming at being the free-and-clear landlord vs increasing our portfolio. I'm a stay-at-home Mom so time spent with kids is more precious than being a high flyer but I have to admit paying down the debt snowball is boring and slow, especially with modest returns.
@Matt H. If we drop hyperinflation from the options (yes, it is an alarmist position), there is still quite a spread between the options. Do you feel stagnation is equally alarmist, or does that one remain as a legitimate possibility in today's economic climate?
Oh gosh, let's be clear I signed up for Econ 101 Freshman year of college Tue/Thur at 8:20am and then slept through like 17 of the 20 classes.
No one can be sure what is going to happen, my main point was if you are going to buy a building today I am pretty certain hyperinflation is not an immediate concern.
Let's define stagflation: "Persistent high inflation combined with high unemployment and stagnant demand in a country's economy."
In this case high is not defined so in my mind it is already a more likely scenario than something going up 50% on a monthly basis. My personal view is that is it also not likely in the near term.
People can't agree on what causes stagflation but the two main theories are a supply shock (usually oil) or poorly made economic policy. I'd say the former shouldn't be an issue in the near term but of course the latter we can argue till the cows come home. Janet and company are certainly controlling things with economic policy.
So I would say in my opinion both hyperinflation are stagflation are both unlikely but not equally alarmist.
My view is that everyone's concerns, especially with respect to the US debt and monetary policy are valid. But I think everyone forgets the United States is a freight train, the most powerful in the world today, perhaps in history. So even when you make mistakes, it will take quite awhile for it to come of the rails. We may be able to fix it, we may not, but near term we have some pretty smart people and a lot of horsepower under the hood to keep it moving along.
This is now too long but I'd also add real estate prices are now getting higher and I'm a buyer every year regardless. In 2016/2017 I'm making sure I buy smart as a pull back is possible, but I'm not concerned about some near term cataclysmic economic event.
Matt
@Matt H. Do you follow Sean O'Toole of Property Radar? He's definitely of the opinion that "flat is the new black" and sees a Japan-like scenario a real possibility for the US. Sean is definitely a pessimist, but by no means an alarmist. I would concur that the US economy is a freight train, but right now I'm not feeling convinced that the price appreciation we've seen isn't largely from falling interest rates and government intervention.
BTW, I'm pretty sure I never slept through my Econ 101 class but that's just because I don't even remember taking it :)- I'm no expert, just trying to make wise decisions given the current climate.
@Natasha Keck I am ashamed to say I don't really follow much of anyone. I'll have a look at Sean's stuff. I've been head down working pretty hard last couple years. I hopped on this site fairly recently looking for some people to chat with about big buildings. I'm sure they are out there but mostly it seems people are a little earlier in their careers here and I feel like I could help a little. I had a couple of people help me with advice no fee no program just because when I was starting out. Your topic caught my eye, I am by no means an expert on the economy, maybe even the opposite. I'm a pro at buying, selling, financing and leasing apartments and houses. But I like to learn so this thread was interesting although some of these posts I had to take a snack break.
Matt