Vishal from Ottawa asks,
“I listened to your interview with Aaron Chapman on the weekend. You were both talking about how inflation can benefit investors, and I didn’t quite follow how that works. Can you explain it in a little more detail, maybe with an example?”
First of all, let’s start with a definition of inflation. Inflation means the growth of something. Often we think of inflation of prices as being the issue. In fact, increasing prices are not the actual inflation. They’re a symptom of inflation. The true underlying inflation is the inflation of the money supply.
Prices rise for one of two reasons. Sometimes they rise against our will, but more often than not, they rise because people are willing to pay more. The only reason they’re willing to pay more is because they have more disposable cash available.
I’ll give you a simple example. A cup of Starbucks coffee costs about 25 cents if you buy the big bag of Starbucks coffee at Costco. That same cup of coffee costs $2.45 if you buy it read made at Starbucks. People are willing to pay almost 10 times the price of a cup of coffee, not because Starbucks is forcing them to pay more, but because they’re willing to pay more. It’s the availability of that extra cash that enables Starbucks to charge 10x the price of a cup of coffee.
So let’s extend that concept to real estate. I think we would all agree that most people have not saved up enough money to buy a house. That’s why they go to the bank and borrow heavily, some as high as 97% of the purchase price. It’s the availability of that extra cash at low interest rates that enables people to offer higher and higher purchase prices in the market.
It’s not that prices are being driven by the sellers asking too much. When sellers ask too much, houses don’t sell. If they sell quickly or homes sell over asking price in multiple offers it’s because the buyers have access to more cash.
So where did all that extra money come from? It was loaned into existence. We think of central banks calling down to the printing presses in the basement and asking them to start printing some more sheets of $100 bills. That’s not really how governments print money these days. It’s simply the addition of a line item on a general ledger on the central bank’s balance sheet.
So now let us look at how an investor can use inflation to their advantage. In our example, you’re going to buy the home with conventional financing. You’re going to put $200,000 in equity and borrow $800,000.
In our example, let’s say that inflation is 10% per year. At the end of year 1, your property that you purchased for $1M is now priced at $1.1M. The principal owing on the bank loan is still very close to $800,000. For the sake of simplicity we’ll say you still owe about $800,000. But now you have a property worth $1.1M and your equity in the property has increased by $100,000. It’s not truly $100,000 because the increase in price is only an illusion. What’s happened is the value of the currency has fallen by 10%. So that $300,000 gain is really 10% less because the currency is worth 10% less. You gain is really $270,000 in last years dollars.
If you then fast forward one more year your property would be worth $1.21M at the end of year 2 and your equity would have increased from $200,000 to $410,000. Again that $410,000 measured in dollars from 2 years ago is more like $332,000.
At the end of 10 years of 10% inflation each year, your property would be priced at about $2.6M in the market. If you didn’t make a single principal pay down on your loan in 10 years, you would still owe $800,000. But your equity would have grown from $200,000 to nearly $1.8M in just 10 years.
If you had never borrowed the money, and without inflation, you could never have made that rate of return.