Cutting Edge Insights
with Dr. Lee

Inflation – Real Estate Profit Center #5

“Inflation” has 9 letters; don’t treat it like a 4-letter word 

Inflation is usually regarded as and treated like the enemy.

As consumers, it is our enemy.  It erodes the purchasing power of our currency.  We need to pay more and more, and we get less and less.

The government wants some inflation – it is a simple way for the economy to appear as if it is growing.  But it doesn’t want too much inflation – in which case its guaranteed obligation payments (Social Security, Medicare, etc.) could appear as if they are not keeping up.

Inflation is tied to the cost of living, but loosely.  The Consumer Price Index (CPI), according to the Bureau of Labor Statistics, “is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.”

The government has changed how it measures and reports inflation/CPI many times over the years to make the numbers appear more palatable and not evoke fear within the consumer.

If you are saving or investing, you want to aim for a rate of return that exceeds inflation – otherwise you are actually losing ground.  That’s why the sayings, “cash is trash” and “savers are losers” are thrown around by Robert Kiyosaki and others.  (Yes, Uncle Dave, everyone needs an emergency stash.  We’ll fund that first).

In a previous post (here), we alluded to the value of a 30-year fixed rate mortgage.  In my opinion, the highest and best function of the 30-year fixed rate mortgage is to 1) free up cash that otherwise would be allocated to a higher monthly payment while 2) not requiring any more money down to attain the preferred cash flow.

Maximizing your cash flow and redirecting the excess toward other investments is one way of having your money work for you, because you already know how hard you work for it.

Q: But can we beat inflation with debt?  In other words, we know we have to beat inflation with our overall return for our investments to grow in value over time.  Can only one of five ways that real estate pays you beat inflation by itself?

A: Yes.

The mortgage payment on a real estate investment 1) helps determine the cash flow and 2) provides the ability to hedge inflation with a fixed payment.

Q: (Tangentially) Can you ask your banker for a loan to invest in stocks?  Yes, I know your trading account has margin, but can you actually borrow money from your local bank and secure it with equities as collateral as well as your ability to invest in them?

A: In most cases, no.

Real estate investments actually grow a 5th way, and this is yet another way that Wall Street doesn’t.  That is, you retire the debt with dollars that are worth less (at that time you are paying them back) while the rate at which you pay them remains the same.

In other words, you’re paying back today’s debt (as an example) with future, devalued dollars.  The dollars I use to retire the last year of debt on an investment, in that future year, will be worth considerably less than the same dollars today…yet the dollar amount of the payment is the same.

There are economists who will argue with this assertion.  One argument I read is that, “If I were to take the proceeds from a cash-out refi and invest in a laddered bond portfolio with a maturity date and expiration exactly matching each and every one of the 360 payments, at the end I would come out the same.”  In other words, that there would be no net gain after 30 years.

I’m not an economist – but I don’t think purchasing 360 bonds, shouldering the risk, paying the transaction costs, settling for a low return – would be high on anyone’s “I wish I could invest in that” list. 

{It’s not anywhere on mine.}

There are others who will argue against a 30-year mortgage, citing the added interest that will be paid over the life of the loan.  While that is partially true (yes – more interest is paid), a deeper dive shows that since the smaller amount of interest is paid off faster, a 15-year mortgage actually costs more in inflation-adjusted dollars.  Although the proof is beyond the scope of this article, reach out if you are interested and I will direct you to the appropriate resources.

An important point:  when discussing how real estate leverage beats inflation, each one of the previously-discussed factors (here, here, here, and here) have to be in place to maximize return.  For example, if rent revenue doesn’t keep pace with inflation, I can assure you that your operating expenses (repairs/maintenance, insurance, etc.) will increaseand your returns will suffer.  Some geographic locales simply don’t have the demand that others do as a result of a multiplicity of factors – and it may be tough to forge decent returns in these areas.  As the “Real Estate Guys”, Robert Helms and Russell Gray, always say, “Live where you want, but invest where the numbers make sense.”

Q. Can you give me a real world example of how this would work?

A. Sure, let’s go back in time to 1989.  Median home price was $97,000 in 1989 dollars.  Thirty years later, median home price was $227,000.  Over 30 years, that’s a 2.34x factor of increase. (as an aside, median rent went from $358 to $1,005 – a factor of increase of 2.81x.  Important note:  median rent in this case applies to all real estate asset classes, studio apartments, homes, etc.; don’t get hung up on the connection between a $227,000 home and a $1,005 rent.  That definitely wouldn’t work)

Your 80% mortgage in 1989, on $77,600, would have been at 9.74% interest.  Yes, you refinanced a couple of times along the way (in 1993 at 7.68%, 2003 at 5.48%, and 2012 at near or slightly below 4%, but you never reset the term and paid it off in 2019).

Payments in year 1 total $7,992 in 1989 dollars and payments in year 30 total $5,496 in 2019 dollars.  But a 2019 dollar is only worth 0.47469 of a 1989 dollar – so your final year of payments is “valued” at $11,578 in 2019 dollars…when you consider what you’d have to pay in 2019 if you decided THEN to purchase the same asset for which you locked in financing in 1989.

And you would have never made the investment in the first place had the payments been that high.

This is the value of inflation as it pertains to our leveraged real estate investments.

As you think about that, pay close attention to the messages and hype from mainstream and well-known financial advisors.  Manage your finances in a way that allows you to sleep at night, but at least understand how inflation erodes that value of your debt.

Until next time,

Dr. Lee Newton


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