Why Fears About Looming Inflation Are NOT Overblown

If you’re less than 75 years old or so, this is the weirdest economic situation of your lifetime. And that’s saying something. We’ve had stagflation, the dot-com bubble, the housing bubble, and the ZIRP Fed policy, not to mention the devastating discontinuation of the volcano taco by Taco Bell.

Today, we’ve got a small handful of companies responsible for all of the gains in the stock market, which has reached pre-crisis levels and is pushing toward new all-time highs.

Someone didn’t tell the main street economy, though, where we’ve now had 20 straight weeks of initial jobless claims that have been significantly higher than anything ever recorded before March 21^st.

In the institutional realm, where I play, valuations on apartments and self-storage have been closely tied to debt costs, and plummeting interest rates have driven down cap rates in kind. A cap rate starting with a 5 now looks like a steal.

We’ve got to sort through insane amounts of money creation by the Federal Reserve, massive deficits of the U.S. government, and extreme strain on state and local budgets across the country.

The monthly federal deficit was $864 billion in June. MONTHLY. That’s higher than all but five ANNUAL deficits we’ve ever had and higher than any annual deficit prior to 2009. And it will get worse before it gets better.

And that’s really the crux of the matter that I want to discuss. Take a look at what has happened since the dot-com bust and how sharply the problem accelerated after the great recession:

There’s been a fundamental shift in the way the government operates. Deficits be damned, just borrow and spend. This behavior has been enabled by the Federal Reserve, which monetizes the debt performs quantitative easing by buying up Treasury securities (and now CMBS, junk bonds, and ETFs), which creates artificially low interest rates and allows the government to get away with spending money they don’t have—and have absolutely no prospect of paying back.

The Inflation Monster

I know what some of you are thinking right now. “Phil, we’ve had 12 years of this Federal Reserve policy and extremely low inflation. Stop crying wolf all the time. A broken clock is right twice a day. You could stand to lose 10 pounds. Your wife is way too hot for you.”

Gosh, the internet is mean sometimes.

But here’s the deal. I think we’ve had inflation in a few ways that don’t show up in the official statistics.

If we want to define inflation in the snooty economist way, fine. CPI growth has been very muted. But I think of inflation as too much of a given currency chasing around a finite amount of stuff.

If we want to lump everything together in consumer goods and look at the averages, we’ll be missing the nuance. What about the exploding stock prices, bond prices, and real estate prices, despite little to no revenue or earnings growth?

What about the inflation in single-family homes, higher education, and healthcare? If you’re entering into middle age, prime earning years, you’re probably disproportionately facing all of these costs as you try to get into a good school district, save for college, start seeing more healthcare expenses, and potentially need to start sharing in the cost of care for elderly family members.

But hey, at least your flatscreen is dirt-cheap!

Now tie that into what we’re seeing today. Massive government deficits. Round after round of “stimulus.” Trade wars that can only put upward pressure on the prices of the few things that were actually cheap for us. As the rest of the world comes to realize that our government is incapable of getting this under control, the strength of the dollar will decline.

To be sure, other countries will try their best to destroy their currencies at an even faster rate, so the dollar may actually hold up in relation to the Euro or Yen. But how will it hold up relative to a share of stock? A box of Cheerios? An ounce of gold?

If interest rates were to go up, it’d be game over as borrowing costs spiral out of control, causing massive defaults, bankruptcies, and total insolvency of the federal government. So the Fed will continue to throw everything they’ve got into destroying our purchasing power saving the world and ensuring that corporations and rich dudes thrive the economy has sufficient liquidity.

We’re already starting to see some cracks form.

How to Capitalize as a Buy and Hold Real Estate Investor

Thankfully, buy and hold real estate is a great place to be in this macro environment. We’ve got a window here before lenders and bond investors realize what is happening where we can take advantage of borrowing increasingly worthless dollars and turning those dollars into real income-producing assets.

You see, banks don’t want to lend money in inflationary environments, especially at long-term fixed rates. For example, if I lend you money at 3% a year but inflation is 4%, every year I’m actually getting paid back less in real terms than I lent out. I’m guaranteeing myself a loss.

But for now, it’s happening. It’s happening largely due to government involvement in the space, as well as a lack of understanding about the serious risks of inflation coming this way.

Regardless of why it’s happening, it’s creating an opportunity.

Please, for the love of Pete be careful. I’ve written on this site multiple times about the dangers of using leverage and how it’s the fastest way to go completely broke in real estate. Debt is a fickle mistress.

But if we do it right, here’s the benefit in a simplified example:

I used 100% inflation to illustrate the concept. I know this is not realistic. Chill out.

Here we can see that because the debt payment is fixed, as rents and expenses increase due to inflation, more of the cash flow after debt service drops into our pockets. And the value of the real estate increases, even at higher cap rates. But you’re also going to be spending $13 on a box of Cheerios.

The key to really capitalizing here would be getting the longest possible term on the fixed-rate loan, so that as inflation compounds, more of the benefit accrues to you. The longest terms I can think of are Fannie/Freddie loans and HUD loans. Actual banks that must hold the loans on their books and follow that pesky capitalism thing are probably going to be the first to wise up. But the government gets to offload the losses to the taxpayer, so those loans will likely remain available.

Larger apartment loans tend to max out for the agencies at around 15-year terms (some exceptions), but HUD debt can be 40 years (and comes with a bajillion pages of red tape).

One- to four-unit apartments may be the sweet spot here, as 30-year money is available there, though it seems like this space is also hyper-competitive and home to some of the “worst” investors who love to pay up for everything.

And hey, if I’m wrong about inflation, if you buy good deals in good markets, you stand a good chance of coming out ahead anyway!

Finding the Right Deals

Obviously, there’s much more to the macro picture than just inflation. Finding the right renters, with the right jobs, in the right parts of town is extremely important right now. I think the time has passed where you could buy anything and manage it with mediocrity because rent growth and cap rate compression would bail you out.

Until next time, amigos.

Do you have predictions about inflation and associated repercussions?

Join the discussion in the comment section below.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.