Where and how you place your investment capital is critical, especially in an inflationary market.
What do you think the current rate of inflation is?
I start every conversation with investors with that question. Much too often I hear “2%-3%” in response.
A common number in recent years, that number is now quite a distance from the “official” numbers.
Let’s take a look at how we measure inflation.
PCE and CPI
The Personal Consumption Expenditures Price Index (PCE) and the Consumer Price Index (CPI) are the two most commonly referred to indexes for inflation. The published data from the Federal Reserve indicates CPI at 6.8% at the time of this writing.
Each index is very specific in its measurement and focus.
The CPI is a statistical estimate constructed using the prices of a sample of items whose prices are collected periodically. The PCE price index is a narrower measure. It looks at the changing prices of goods and services purchased by U.S. consumers. It’s similar to the Bureau of Labor Statistics’ consumer price index for urban consumers. Each of these inflation indices refers to specific items that are measured and tracked, and most items can be controlled by the Federal Reserve’s monetary policy.
However, if you view inflation as a reduction in buying power, other economic indexes, in my opinion, better illustrate the true change in cost of living for the average American. They consider a wider array of expenses that impact consumers and factor in how location impacts expenses. For example, the PCE attempts to identify underlying inflation trends by excluding two categories—food and energy. However, food and energy are two significant necessities for all consumers.
Take a look at John Williams’ www.shadowstats.com and Ed Butowsky’s www.chapwoodindex.com for comprehensive data on inflation. Your eyes will be opened to the “wizard behind the curtain,” and you’ll better understand how the placement of your investment capital is very critical.
Why Real Estate Investors Benefit from Inflation
The properly leveraged real estate investor is one of the very few who reap the greatest benefit from inflation.
Many have argued that inflation’s erosion of the dollar reduces debt—and they are right—but I have not found anyone to give more than theoretical sound bites on the subject. To provide more meaningful data on the subject, I partnered with Dr. John Abernathy from the accounting department at Kennesaw State University to provide calculated evidence of the real “debt erosion.”
Understanding “Good Debt” vs. “Bad Debt”
Before we get too much further, let’s tackle the notion of debt. We are all familiar with the concept of “good debt” and “bad debt.”
I would not look at properly leveraged real estate as “debt” at all. Debt is something that hangs over one’s head as an obligation, and it follows a person around until the debt is satisfied—with only the person’s resources to draw from for repayment. With properly leveraged real estate, however, the investor has what can be considered the least liability in the transaction. Sure, the investor must guarantee the repayment, but consider the benefits as a middleman between those who have issued the funds for finance and those utilizing the asset for their personal use.
Often metrics such as “cash on cash return” and “cap rate” are offered as ways to analyze a real estate investment’s potential as a good investment. These are good metrics, but they don’t offer the complete view of how a real estate investor fully benefits.
Such calculations are a way of determining, in a fast-paced world, whether the opportunity provided via proforma is one worth taking a deeper dive into. When taking that deeper dive, I prefer to look at the property’s appeal to the potential tenant. In addition, would it be the type that would remain reasonably occupied for the duration of my ownership? Lastly, is it a market in which I can raise rents?
If the real estate investor, as the CEO of their real estate investment business, is capable of making the correct decision about who they work with on the acquisition, management, maintenance, and finance, then they can have a much more significant outcome than what is offered on the common proforma.
Crunching the Numbers
Using some baseline numbers, let’s explore what these returns could be. Let’s use a $150,000 acquisition price, with 20% down, a 0.8% rent-to-value ratio, a 30-year fixed loan, and $200 per month cashflow. Every market is different, and every outcome has its variances, so these numbers are for illustrative purposes only.
So, let’s assume the real estate investor did their job and chose the right people to work with, selected the right business (property) to purchase, and kept it reasonably rented for the entire time of ownership. Who pays off the financing?
If you said, “the tenant,” you are correct. Over the life of that 30-year loan, tenant rent payments will be used to satisfy the terms of the financing.
Let’s do the actual calculation. The simplest way to see what kind of return was received just for the amortization would be to calculate the amount of the financing itself. On $150,000, 80% is $120,000. Dividing $120,000 by 30 (the number of years to pay it off), gives you $4,000. That means the tenants will pay down $4,000 a year off the financing averaged over 30 years. (Yes, I realize the amortization table doesn’t look exactly like this, but, remember, we are aiming for simplicity with this illustration). Now, divide the $4,000 by the investor’s initial investment, which would be considered $35,500 (20% down on the $150,000 purchase, plus $5,500 in closing costs for the lender, title, appraisal, inspection, etc.)
If you divide the $4,000 average increase by the initial investment of $35,500, you will find that the $4,000 is an average 11% increase on the initial investment year after year for 30 years. Already this investment is getting an intriguing return, and we have yet to discuss the cashflow or tax benefits or to hedge against inflation.
Looking at the cashflow, we have determined $200 per month as a potential income for a $150,000 property. Many would shy away from this investment because the potential income is too low and may not meeting the “cash on cash” return requirements they set for themselves. Nonetheless, let’s see if we can find a benefit to a property that may have been overlooked in the past.
If such a property were available, and we felt confident we could retain renters and also raise rents, we should take the time to pencil out that growth over time. We should not get caught up in the first couple of years of cashflow. I have seen that shortsightedness derail many a great deal.
Let’s take a close look. In Year 1, $1,200 per month rent (0.8 rent to value ratio/ RTVR) would provide $200 per month cashflow. The property was purchased partly because of the ability to raise rents. That being said, what is the average rent increasing by these days? Double-digit percentages are being quoted across the U.S.—I have seen averages of 10% published. For the purpose of this example, let’s beat down that number to a 3% average rental increase for the foreseeable future of this property.
So, 3% of $1,200 is $36—nothing earth shattering. That kind of increase doesn’t get the real estate investor excited, and it does not freak out the renter either. That means that in Year 2, the rent becomes $1,236, making the cashflow plausibly $236. Do the quick math and you find that is an 18% growth in your cashflow. This is compound growth. Every time you raise the base rent by 3%, you get potentially an 18% growth in the cashflow. That’s very exciting.
But that’s not the best part. Does the lender receive an increase in the payment of the loan to pace inflation the way the investor does? No, the loan is a 30-year fixed loan. In fact, inflation running rampant and devaluing the dollar so rapidly causes the lender to receive a compound decline in repayment.
Let’s use the rate of 6% to work out the numbers. We are not that high presently, but let’s beat this equation up a bit. With a payment of $719.46 per month for 30 years, we have a total of $259,005.83 principal and interest over 30 years. But, remember, every time a payment is made in our high inflation environment, the dollar spent is worth less. You can calculate each dollar each year for 30 years using the amortization calculator included with the QJO Investment Tool app, which can be downloaded from your app store. You will see that the value of those collective dollars is $98,050.61. The investor paid back 81% of the initial balance in real dollar value.
Please visit www.aaronbchapman.com to schedule a time to discuss this topic in more detail. Also visit the Loan Process tab for more information on financing with my team and the app.
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