The only “hedge” against inflation that we are aware of that works consistently over time, in any market, and any economy is real estate. Well bought real estate can stand the scrutiny of analyses, using historic or current data, by investing using borrowed money.
To be clear, the ability of real estate to provide a real hedge against inflation only works if you get a mortgage to acquire the property. If you use your own cash, then this capital will be ravaged by the same inflation, and in a similar manner, as if you had purchased anything else.
Although we argue strenuously that there are other benefits of investing in real estate. However, the greater the proportion of the purchase price that is funded using borrowed money, the greater the inflation-beating benefits to you.
And this is where we come to one of those great benefits of real estate that is easy to miss. Since real estate prices are subject to inflation, by borrowing the purchase price (or a large proportion of it) you can largely beat inflation, and real estate is also about the only asset class against which banks and financial institutions will let you borrow money in the first place. It's a marriage made in heaven!
All you have to do is understand these simple concepts, and then go out and judiciously borrow and buy to your heart's content, knowing that everything you own (except the value of your mortgages) will go up in value with inflation.
Strategies to Benefit from Inflation:
- Lock in your mortgage interest rate. Mortgage interest rates can fluctuate dramatically, especially during inflationary times, so fix your interest rate for as long as possible when they are low. In the United States it is possible to have interest rates fixed for the entire term of a 30 year mortgage (and even 40 year mortgages in some cases) so we are at a loss as to why so many people opt for a 3-year ARM (where the rate is locked for only the first three years and then reverts to market rates). Do not be seduced by an initial ARM interest rate that may be half a percent lower than a 30-year fixed rate. The gains will be wiped out and then some when the ARM goes to market rates. Lock your rate in for as long as possible.
- Never sell! Inflation rewards people who hold on to their real estate through two mechanisms. First, with inflation, rents tend to go up, so that your cash flow improves, making mortgages easier to service (we are referring to the interest component!). Secondly, as a result of increasing rentals, capital values tend to go up as well. When you sell a property, you never earn another dollar of rental income, or reap the benefits of another dollar of increased equity. Plus, if you sell, you will probably have to pay capital gains tax and depreciation recapture tax. Not selling is a strategy that has stood the test of time except for extenuating circumstances.
- Avoid paying off principal. People seem obsessed with paying off their mortgages, even deploying “mortgage acceleration” tactics to pay their mortgages off even faster. Paying your mortgage off is a better strategy than squandering the same money on frivolous items. However, you would be better off deploying the capital saved in paying off mortgages on further investments. The reason is very simple: mortgages are borrowed funds, and inflation decreases the value of what you have borrowed. Of course the size of the debt will remain the same – a million dollar mortgage not paid off will still be a million dollar mortgage in thirty years time. However, it will be much easier to come up with a million dollars in 30 years because of inflation. To put it another way, if you had a million dollar mortgage, and suddenly won a million dollar lottery, would you be financially better off to use the lottery winnings to pay off the mortgage, or to use the lottery winnings as a down-payment on another $10 million of real estate? Buying the real estate will be much smarter. If this holds true for one lump of $1 million, then it should also hold true for ten lumps of $100,000, or 100 lumps of $10,000, or whatever your monthly principal repayment is. What is more, principal repayments are not tax-deductible, whereas interest payments often are (sometimes only on income-producing investment properties). To put it another way, inflation increases the value of your property, and decreases the value of the money you borrowed to buy the appreciating asset.
- Choose high-growth areas for investment. There is a direct correlation between population growth and the capital value growth of real estate. Unlike trends in the stock market, which can appear and disappear in a week, growth trends in real estate tend to be very long-term, easy to track, and easy to take advantage of. Why buy a property returning 28% in the backwaters of nowhere, if the population growth is negative and your tenant may have left town before the week was out? The benefits of inflation are even more dramatic on real estate in high growth regions.
- Add value for instant equity jumps. Usually, with a relatively small capital outlay, you can tremendously increase the value of a property. We know of no other investment where, once you have invested, you can add a relatively small lump of extra capital to achieve great lumps of increased equity. Inflation simply amplifies the benefits this process.
- There is no time like the present. There is a caricature of the real estate investor who waited for the perfect time to enter the property market, a skeleton sitting at a desk, covered in cob-webs. Prices are at historic lows, inflation is about to kick in, and interest rates are low. Take action!
If you are new to the game of investment cycles, or if you are simply too young to have experienced previous cycles, then we can understand that you are wondering whether our admonitions to go out and invest NOW are sound pieces of advice or simply ratings. However, when you have been through a couple of cycles before, you start to see the patterns. What we have at present is quite literally a Perfect Storm from which some smart investors will benefit tremendously, while others who equivocate and hesitate will see yet another spectacular opportunity pass them by.
Experience may be the best teacher, but remember, it does not have to be your own experience! We do not feel inclined to try cocaine to know – through experience – whether we want to indulge. We are happy to rely on the experiences of others. Similarly, you can rely on the experiences of others regarding real estate cycles, both those people who missed out on the last opportunities, and those who took a stand and capitalized tremendously from them.
Both groups will agree that what we are experiencing now — a combination of low prices, imminent inflation, low interest rates, and high skepticism as to the long-term benefits of investing in real estate — presents opportunities that we may never again see in our lifetimes. The time to act is NOW.