What is inflation? In economics, the topic we’re interested in today, inflation is a general increase in prices and fall in the purchasing value of money (thank you, Google). Now, there are all sorts of reasons that things change prices. A corn fungus could drive up the price of good edible corn, a beanie baby craze could drive up the price of beanie babies, but we’re not talking about that today. We’re talking about an increase in price that’s specifically caused by a DECREASE in the value of the money. For most people, a dollar is like a centimeter or an inch; when they think about economic value it’s just another dimension by which to measure a thing and that thing is measured in dollars. For example, a jug of milk is 10.25 inches tall, 5.5 inches wide, and worth 3.82 dollars. Centimeters, inches, and dollars are all human mental constructs to help us think about things, but centimeters and inches are very carefully defined not to change so that said jug of milk, whose true dimensions are not changing, will stay 10.25 inches tall and 5.5 inches wide. Not so, dollars.
It’s very important that money be able to serve its purpose, which is as a medium of exchange, and because of that it generally needs to change slowly or people won’t feel comfortable accepting it in their transactions, but over time or distance the change can be very clear. Consider the graphic to the right describing the cost of some goods in San Francisco at the time of the survey compared to the national average price. Do you suppose that a dozen eggs or a pound of rice feed any fewer people in San Francisco than they do in the rest of the nation? No, they don’t, what’s happened here is only what’s common in many large cities: the value of the money has dropped.
The value of money also tends to drop over time, and here’s where things get interesting; we as a nation want it to, and we try to make sure that it does. We here in the USA have the Federal Reserve that influences monetary policy and, among other things, attempts to cause the dollar to lose enough value to create a 2% overall increase in prices each year. Now the Federal Reserve doesn’t have the last word on something so general as the value of the dollar, indeed no one does or can, but their abilities are nothing to scoff at, and they get close to their target more often than not.
Why inflation is good for our nation is definitely beyond the scope of this blog, but why is it so good for real estate? That I can answer. Most real estate investors buy and hold their properties with mortgages, and almost all of those mortgages are fixed-price. What does that mean? Fixed-price means that fulfillment of the contract is based on a certain price, but not necessarily a certain value. If you borrow $100,000 from a bank, then pay your fees and interest, when you pay back the loan, you’ll pay it back with $100,000… the same number of dollars you borrowed. We just established though that our Federal Reserve attempts to and usually succeeds in causing dollars to lose value each year. So if you borrow that money one year and pay it back 5 years later, you’ll be paying back something of very different value than what you borrowed!
While money tends to go down in value by design, real estate tends to hold value very well and even increase in value. To keep things simple though, let’s consider an example real estate investment that simply held whatever true value it had and examine the effect of inflation on it when paid for with fixed price debt. Let’s suppose that the property, through rent, pays all of its own costs and then exactly enough to cover the interest on the mortgage. In the case of a $500,000 house with $400,000 worth of fixed price debt on it, if the Federal Reserve hits its mark, the house will gain the debt times the inflation rate in equity: $400,000 times 0.02, or $8,000. Which, on the $100,000 dollars of starting equity is an 8% real return (it will look like a 10% return because the equity will inflate too).
8% isn’t world shattering, but ask yourself how much work you’ve ever done to help the Federal Reserve hit their inflation target. Not much? Join the club. That’s what really makes inflation so exciting, real estate investors investing in totally mediocre projects can still hope for a reasonable return just for using fixed price debt instruments in an environment with inflation! Inflation is truly the wind at our backs financially, and I’ve yet to encounter a better way to set my sail to it than real estate investment.
Here’s hoping you find a way to let the Federal Reserve work for you too!