Sunday, January 18, 2009

Let Inflation Work For You

An investment strategy for these times is to buy real estate with borrowed money, let inflation raise rents and property value over the years and pay off your fixed mortgage with weakened dollars. Assuming you put 30% down and property values increased 60% over five years because you’re getting a good deal now and there’s inflation, you could double your money just from the appreciation alone, rental income increases not considered. The recent 2009 Forbes Investment Guide talked about this strategy in its editorial letter.

A key assumption is that the US will face inflation in the coming years because the government is now printing money excessively to fight the recession. Where do you think the bailout money is coming from? It’s coming from the printing press and the government is creating money out of thin air! When the supply of dollars increases, its value decreases. Maybe not now because of the recession but it will happen after the recession, when a dollar is not worth what it was 2 years ago. Simply because at that time, there will be a lot more dollars out there, as result of the printing machines running round the clock these days.

The Bretton Woods international monetary system in 1944 fixed the value of the dollar to gold. Effectively, this maintains an intrinsic value for the dollar because its value is based on the value of a real asset. However, this peg to gold was removed in the 1970s. Without pegging the dollar to a real asset, the dollar’s value is now just based on the government’s promise to pay. Our government is creating money out of nothing, money that is backed by a government’s seal and strong words of promise to pay. We now know that merely promises and reputation, whether those of the US government or those of the formerly powerful financials companies, is not enough to maintain value. Value has to be based on a real, productive, in demand asset.

Economics tells us that when there is too much supply, value decreases. This is expected for the US dollar. The US government is now printing billions and perhaps trillions to bail out companies and stimulate the economy. These days, numbers like $700 billion is thrown around like it’s a small amount. In the near future, numbers thrown around will be in the trillions. The resulting inflation means prices will increase. Prices of eggs will increase because of inflation. Prices of milk will increase because of inflation. Rents will increase because of inflation. Prices of real estate will increase because of inflation.

Why buy real estate instead of stocks, bonds or simply keep your money under the mattress? I’m proposing real estate because it’s a real asset and prices of real assets keep pace with inflation. Buying a stock is just buying a promise that you own a piece of a company. We’ve seen 5 years of stock market wealth vaporize in 1 year. High dividend paying stocks, ones that because of low stock prices, are yielding 7-9 percent divided, still do not escape inflation. If inflation is at 5 percent, a 7 percent dividend is only 2 percent in real terms. The same applies to bonds.

But with real assets, whether real estate or gold, prices rise with inflation.

Fixed Mortgage Payments Will Stay the Same

If you purchased a property with a fixed mortgage, the monthly mortgage payment will stay the same. While you benefit from increased rents and higher property values because of inflation, the lender that lent you fixed rate money gets paid back the same amount for the next 30 years. In real terms, your income increases because of inflation while your debt payment decreases because a $1000 mortgage in 5 years is worth a lot less than $1000 now.

How to Proceed?
Another key assumption is that you have to buy at the right price, not at the bubble price. You need to buy in areas where property prices have declined significantly and where the values are justified. A rule of thumb is that prices are reasonable if, with 30 percent downpayment, your rental income can cover your carrying costs. Otherwise, prices are still too expensive. Using this formula, prices in New York City are still too expensive. You may find better deals in places with a ton of For Sale signs and where prices have decreased 30 to 40 percent from its peak. Do your homework.

The savvy investor buys now to take advantage of the large supply of For Sales out there. At the right price, your rental income will at least be able to cover your carrying costs if not generate a positive cashflow.

This is an opportunity of a lifetime and if you believe the US will see inflation in the near term, this is a strategy worth considering. Most people know real estate is about location. Few know it’s also about inflation and currency valuations because real estate is a real asset, not just a piece of paper with a fancy seal and promise.

Weimin Tan is a real estate entrepreneur with businesses focused on investments, property management and brokerage. He can be reached at