If You Want to Be a Savvy Investor, Be Wary of These Inflation-Related Myths
It’s easy to find an opinion on anything and everything these days. While hearing out the opposing views on the real estate market can be a great way to make informed decisions on investments, the truth is that some of these opinions could use some scrutiny.
As such, it’s important to provide some clarity and additional insight regarding some commonly held real estate market beliefs—especially as they pertain to inflation. There are plenty of myths surrounding how inflation will affect real estate, and if you aren’t careful about what inflation-related real estate opinions you buy into, the wrong opinions could drive how you choose to invest.
That said, these are complicated topics with myriad factors at play. It’s tough to predict what exactly will happen as inflation impacts real estate, but what we cando is start with what we know to be correct and then add in sound logic. By doing this, we may be able to draw conclusions that are different from what you’ve been hearing about this subject matter. Let’s start by breaking down two common inflation-related myths.
Myth #1: Inflation is good for real estate investments.
One common belief is that inflation is good for real estate investments, but at best we can call this one a half-truth. There are some circumstances in which high, sustained inflation over many years can be great for real estate owners. That said, this is largely predicated on your debt structure.
If you’ve got a long-term, fixed-rate loan, like the loans that can be obtained through Fannie Mae on 1-4 family properties, or 30–40 year term HUD debt, you can absolutely crush it during periods of high inflation. That’s because your payment stays fixed for the loan term, which means that your payments aren’t being directly impacted by inflation.
In turn, rents and expenses go up, but your payment stays fixed, so a larger portion of the cash flow goes into your pocket. The money you do pay back to the bank, on the other hand, continues to lose value over time.
But let’s take a deeper dive into what inflation is and how markets will likely react to it.
Interest rates and inflation
One of the more fundamental economic relationships is the relationship between interest rates and inflation. This relationship makes intuitive sense. Let’s say you were going to lend someone money and the rate of inflation was 3% over the life of the loan. In this case, you would need to get an interest rate of at least 3% just to break even in terms of purchasing power. But breaking even isn’t the point. In this situation, you’d need to get the inflation rate plus a level of real return. Otherwise, what is the point of investing?
The chart above shows the CPI growth alongside the interest rate on the 10-year treasury. It’s clear from this chart that interest rates typically rise as inflation rises. Conversely, interest rates typically fall as inflation nosedives.
While it’s possible that the Fed could hold down the long end of the interest rate curve, I wouldn’t bet on it. If we get truly non-transitory, long-term inflation, the direction for interest rates is likely to trend up.
Now let’s think through the implications of higher interest rates. Those of you who have a working real estate model should pull it up and look at the last deal you bid on. Now raise the interest rate in the model by 2%.
What happened to the returns? How much less would you have to pay to get the same returns as before?
Now extend that concept to the entire market. Buyers simply can’t pay today’s valuations if interest rates go up significantly.
Let’s take that logic a step further. If cap rates are up and interest rates are up, what happens to investors looking to refinance? Well, DSCR ratios are more difficult to hit. Loan proceeds are restricted by LTV at higher cap rates.
Investors that take on high leverage may then find they are unable to refinance, bringing further selling pressure into the markets on a relative basis.
Duration and inflation
A lot of real estate folks don’t think much about the concept of duration, and I don’t blame them. It’s boring investment portfolio theory stuff that’s usually associated with bonds, but every asset effectively has a duration.
You can think of duration as the amount of time it takes to get your money back. It’s a little more complicated than that, but for our purposes that’s how we’ll define it today.
So, for example, a 30-year bond paying low interest is going to have a very long duration. A 30-day bond, on the other hand, is going to have a shorter duration.
Why should you care? Inflation hurts long duration assets much worse than short duration assets.
If I own a 30-day bond, whether or not inflation is high isn’t an issue because I’m getting my money back in 30 days—and as such, it will still have most of its purchasing power.
On the other hand, if I own a 30-yearbond, I have to wait a long time for my cash flow to come back to me. If inflation is high, the longer I wait for my return, the more value my future cash flow will lose.
If I expect very low inflation, I can buy a long duration asset at a relatively low return. But if inflation expectations rise, I can not offer the same price for the asset. I need to get a lower price and a higher return today to compensate me for the purchasing power I am losing by waiting years for my cash flow to come back.
But how does this relate to real estate?
Well, the “duration” on a typical real estate asset is as long as it has ever been. At a 10% cap, assuming no leverage and no value-add, you get your money back through cash flow in about 10 years. At a 4% cap, the duration is 25 years.
Based on what we know about inflation and long duration assets, what would be the likely impact on cap rates if the market believed high inflation was here for the long haul? I think the bias would be toward higher cap rates and lower real estate valuations.
So the next time you read or hear about why real estate investing is the best place to focus during high inflation, think back to the ideas above.
After interest rates and cap rates have been adjusted to reflect the new normal, real estate can absolutely do extremely well for all of the reasons you’ve undoubtedly heard many times over. But at today’s valuations, investors can get into trouble thinking real estate will save them from the inflation monster.
Myth #2: High inflation is here to stay
See what I did there?
I don’t think inflation is a long-term issue. I think a good sign for the top of accelerating inflation was J-Pow at the Fed “retiring” the word transitory. Those guys are always behind the curve. By the middle of 2022, uncomfortably high inflation will likely no longer be part of the mainstream dialogue.
Here’s the logic on this one: None of the long-term economic fundamentals have changed in favor of higher inflation. If anything, the fundamentals have gotten worse and are pointing toward weaker GDP growth and disinflation.
Of course, when the government borrows lots of money and gives it to anyone and everyone with a pulse, prices are going to go up. This was especially true as supply chains were put under strain due to closures and safety measures during the pandemic.
But what causes sustained inflation that lasts for many years?
Well, you either have market participants who are losing faith in a currency due to high deficits—which makes it seem impossible to pay off what is owed without printing money, or you have robust economic demand that outpaces the ability to supply the goods and services demanded.
Let’s take them one at a time:
Money printing won’t cause inflation – at least not in the CPI
The dollar is strong relative to other currencies—and, believe it or not, the U.S. is in the strongest position relative to just about every major economy in the world.
When the Fed buys bonds and “prints” money, what they are actually doing is removing one government liability from circulation—a bond—and replacing it with a 0-duration, 0% interest government liability, like a federal reserve note, bank deposit, or bank reserve, depending on who sold.
The pension funds, insurance companies, and foreign governments that sold the bonds aren’t going to run out and buy Cheerios and dishwashers. They are going to buy another security to store their savings. This is why we’ve had massive increases in the valuation of stocks, bonds, real estate, etc.—but very low growth in the CPI.
Without drastic changes to QE or the Fed printing directly to consumers, the QE programs from the Fed are likely to have the same impact on CPI as they’ve had the past decade—so, not much. The inflation will continue to be seen in asset prices, which isn’t captured in the CPI.
The economy is too weak for inflation
The last inflationary boom we had was in the 1970s. That was a period of very low government debt and very strong demographics. Peak Boomer was born in 1953 and turned 18 in 1971.
The massive wave of new household formation and new families was the driver of inflation at this point. When you’re young and starting a family, you are somewhat desensitized to price fluctuations because of need. You can’t wait for prices to drop to buy a house, dishwasher, diapers, or toothpaste. You buy them—and borrow for them—because you need them right now.
We are currently facing the opposite situation, however. An aging population doesn’t spend aggressively, and birth rates are extremely low. The working age population has rolled over.
There is also strong evidence that high government debt leads to weaker economic growth, and we’ve got boat loads of that:
Fewer workers mean less demand:
Future population growth is not coming down the pipeline:
I love the generation that came before me, but an increasing share of the population being less productive, coupled with net “takers” from the system, puts the burden on a shrinking population base. They must provide for themselves, their families, and input the tax dollars needed to cover the benefits for earlier generations.
This means there is less income to spend today.
At 122% of GDP, debt levels are well above the 90% threshold, which tends to cause significantly diminished economic growth.
When we put all of this information together, we see that the most likely long-term outcome—which will certainly have cyclical fits and starts in shorter time frames—is a slow-growing, less productive economy with low inflation and low interest rates.
While that sounds like a bummer, and it is in many ways, those are also really decent conditions for real estate. With interest rates remaining low, capital looking for a home, and real estate a stable, cash-flowing alternative to high risk and more speculative investments, real estate can thrive in these conditions. That’s barring a recession, anyway—which is certainly on the table.
As such, those hoping to see more inflation to help their real estate portfolios should be careful what they wish for.