Inflation is likely to grow at a larger rate the next 10 years than previously expected. Financial experts nationwide are not in agreement as to the extent to which inflation will grow but most agree annual inflation growth is inevitable. Generally, inflation is regarded as a negative economic growth indicator, but real estate debt can prove to be a hedge of protection for investors.
I have long been a follower and believer in Dave Ramsey’s teaching that people should strive to be debt-free. Most of what Ramsey teaches is sound, and applicable to the average person. My one major disagreement with his debt-free strategies is related to real estate.
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Debt is often looked at as a four-letter word when it comes to personal finance. For the average person, the debt-free strategies Dave Ramsey teaches will have lifelong benefits if implemented. However, for the people trying to build wealth and increase their net worth past only having their house paid off, debt, and in particular, real estate debt, is necessary. Debt isn’t only a necessity for investing– it is essential. Philosophically, I do understand the desire to be debt-free. However, from a financial planning perspective, debt is the best hedge against inflation and is needed to preserve and grow wealth.
The concept is actually fairly simple, and it centers around the concept of the “time value of money.” That means that a dollar today is worth more than a dollar a year from now. There have only been a few years in which inflation decreased. Those years usually followed periods of turmoil or high inflation. Looking at the inflation rate year over year, people tend to forget that the rate compounds on the previous year reducing the value of the dollar and its buying power.
For example: Assume you had $100 in 1989. That year, there was inflation of 4.83% meaning that $100 would only be worth $95.17 in 1990. The next year’s inflation rate was 5.39% reducing the value even further down to $90.04. The inflation rate compounds each year on the previous year’s ending value.
This means that if you invested that $100 and you didn’t earn at least 4-6% each of those two years, your investment lost value. People who put their money in a savings account earning 1% or less are actually losing money every year. The higher the inflation rate the better your investment has to perform just to break even. This is why rental properties have to increase rents every year. If they don’t then their effective rental income is going down every year if the increase in the rent is less than the rate of inflation growth. One dollar today is worth more than a dollar a year from now.
Real estate debt is the safest solution to the inflation problem. The higher inflation goes, the more debt you want to have on real estate.
For example: Assume you purchase a house that is worth $250,000 and you pay $50,000 cash and borrow $200,000 in debt for 10 years. Assume inflation grows at the rate of 3.5% per year on a 10 year amortization. After 10 years, the property value has increased by roughly 30% simply by inflation compounding annually. The property value went up along with the rate of inflation, but the debt continued to decline as it was paid down annually. The debt did not increase at the same inflation rate that the property value increased. Annually, the net worth/equity increased by the amount the debt was paid down plus the increase in value from inflation.
In the same scenario, assuming there had been no inflation, the value would still be 250k and you would only receive the benefit of the principal reduction. This scenario isn’t the worst investment ever since you still grew $200,000 of equity over the life of the loan. But with the inflation in the first scenario, you grew $276,000 or roughly 35% more.
The higher the inflation rate, the wider the distance in the two scenarios returns. If the inflation rate was 5% on a 10-year loan, the growth is $337,000 or 41% more if inflation had stayed the same over the 10-year period.
Investing in real estate is never that simple. The difference in paying cash verses financing the purchase of the property can not only be measured by inflation and rate of return on what was invested. If you only invested $50,000 instead of the full $250,000 you have to assume that the other $200,000 was invested in some alternative investment thus earning an additional return. Combine that with the fact that interest on the mortgage is tax deductible, if it’s an investment property you can depreciate the property reducing your taxes, and the many other tax advantages of owning real estate and you are almost always better off leveraging the property with debt. Other factors could include the cost of the debt, interest rates, operating costs of the property, and holding costs. It is also hard to quantify local appreciation or depreciation of value in a market outside of inflation.
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With the federal government printing trillions of dollars in 2020 and 2021 inflation in my opinion has to increase. Any intro to economics course teaches that as the money supply increases the value of the dollar decreases. As the dollars value decreases, inflation occurs since that same dollar does not have the same purchasing power as it did before. To further complicate matters if a $15 minimum wage is implemented, we will see hyperinflation in certain markets as more and more money is pumped into the market with either the same or less goods being produced.
If and when inflation or hyper-inflation occur, those with debt on real estate will be best positioned to protect their financial assets. Real estate has and will always be the best investment vehicle to hedge against inflation.
Joe Edge is the Real Estate Columnist and Publisher for The Augusta Press. Reach him at joe.edge@theaugustapress.com
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