Ever since the pandemic began in 2020, the writing was on the wall: inflation is coming.
How could it not happen? The money supply increased while the world’s production capacity and output decreased. We had more dollars chasing fewer goods, in simpler words.
As anyone can imagine, that meant that people would have to start paying more dollars to obtain the goods or services they needed.
Since I can remember, the Fed’s goal for inflation has always been 2%. That’s the figure we’ve been told was “healthy”. Then after the pandemic, the Fed announced that it would let inflation “run hot” and go above 2%. Many thought “run hot” meant 3-4% — but it was on its way to something much higher.
Then we were told that the inflation was only “transitory”… In November 2021, Jerome Powell, Chairman of the Federal Reserve, stated: “It’s probably a good time to retire that word and try to explain more clearly what we mean.”
These comments were made as the Consumer Price Index rose to 6.8% from November 2020 to November 2021, the largest increase in nearly 4 decades.
From March 2021 to March 2022, inflation is now sitting above 8% annually. Some would argue that the real inflation rate is much higher than that, but that’s a conversation for another day. Take a look at this chart from the Bureau of Labor and Statistics.
You’re probably saying, “Okay, Michael. I know that inflation is a problem, but what can I do about it?”
Well, I’m glad you asked. There are three simple steps to combat inflation.
You probably expected answer #1 but answer #2 and 3 might have surprised you. Let me explain…
One of the most fascinating and powerful tools within investment real estate is the fact that you can use leverage (debt) to acquire a property. In today’s environment, you can borrow money for 20-30 YEARS at 4-5%.
So if you borrow at 4%, but inflation is 8%, you get to pay back the debt with dollars that are worth less as time goes on. Here’s an analogy:
Imagine you borrowed a cup of water and you got to take a big gulp of it, hold it for 30 years, and then return it to the lender half full. That’s the power of borrowing in an inflationary period.
(Which is what we’ve been in since the dollar was created.)
Check out this chart of the value of the dollar from 1900-2000.
This chart shows that savers are the biggest losers in today’s world. Every day you hold a dollar, you lose purchasing power. Let me give you another example.
I know a married couple who bought their home in 1997 for about $87,000. In 2022, that home is now worth $300,000 easily. Do you think the home has gone up in value, or do you think the value of the dollars used to purchase the home are now worth less?
That home went from $87K to $300K in 25 years. That is an increase of $213k. If they had bought that home for cash in 1997 for $87K, that would be an annualized return of 9.8%. [ (300K – 87K) / 87K / 25 years ]
Now, let’s assume that the couple had used debt to acquire that property. Let’s also assume that they put $20K down, financed the rest, and paid off the debt in 25 years. The annualized return would now be 42.6%. [ (300k – 87k) / 20k / 25 years ]
A quick illustration of how we got these numbers:
You may be saying: “But Michael, you didn’t calculate the interest they paid during those 25 years.” You are right. I am assuming that they used this house as an investment property and the tenants paid the mortgage for the owners for 25 years.
Now, this is a simplified example. It did not take into consideration the positive cash flow the property would have generated for 25 years… the depreciation benefits of owning the real estate… or the fact that the rent they were able to charge probably increased along with inflation during the whole 25 years!
This example was a simple single family home but the concept holds true for apartment buildings, self-storage units, mobile home parks, short-term rentals, office space, industrial warehouses, etc.
The power of borrowing when inflation is higher than your cost of borrowing is extremely powerful. Some even argue that debt is the asset in today’s world. Even though the accountant in me hates that statement, I can certainly understand the argument.
All of the items mentioned above are why I am getting into real assets, real estate specifically, to protect myself and profit from this problem.
If you’re interested in discussing more about how you can combat the rising tide of inflation, please schedule a call. I would love to help you beat back inflation.
