Real Estate Leverage

[Landen Ward]

I recently read an article on how Real Estate is a great tool to invest in against inflation. The used example was a 20% downpayment. After inflation caused the house to double in price, the downpayment was apparently quadrupled? I'm not sure how this works. I would think the downpayment would be cut in half since your downpayment was while more money was contributed to the overall value.

Also, it said something about not having to pay as much towards a fixed loan anymore.

I'm new to this if you can't tell. Thanks!

[Patrick McGowen]

I think the confusion is we start mixing terms around. A property will increase in price for several reasons.

1. You improve the property

2. Inflation

3. The market heats up and properties become overpriced

4. Demand increases (e.g., population growth) more than supply (e.g., number of houses in an area)

I am using the term “price” instead of “value” because I mean that the increase is in how many US dollars you could sell it for. No. 2 & 3 above are not increases in value. It is the same house in the same location.

These increases in price are often intertwined. For example, a bunch of fix and flippers come into a market (item 1), the dollar loses value due to inflation (item 2), jobs and population increase in the area and new building does not keep up (item 4); with these three things happening, everyone sees the average home price increasing and anyone who is able starts buying homes and paying too much (item 3).

I think the other confusion is that we often think of dollars as something of fixed value, but the value of the dollar fluctuates just like everything else. If a dollar buys half as much as it used to, eventually salaries will adjust up for living wage reasons, and rents will adjust up as well. If your salary increases and the rent from investment RE increases, but you owe the bank the same amount with the same monthly payments, it suddenly becomes much easier to make those payments. The mortgage payments are the same price, but only take half the value to pay them.

Generally inflation can only go one way, but the other three items can go both ways so as Michael says be careful, leverage cuts both ways. Inflation is the icing, make sure the underlying value is good (you buy low, have good cashflow, and possibly improve the property).

Sorry I kind of got long-winded. One more thought. If the Federal Reserve target is 2 percent inflation and you buy a property with 20 percent down payment, this is effectively a 10 percent return. Hypothetically a $100,000 property would increase in price by about $2,000 a year based purely on inflation. This increase in equity is a 10 percent ROI when considering your 20,000 down payment. With 20 percent down, you are leveraged 1/5, so increases in inflation is a five-fold return.

Sounds awesome, but investing for inflation alone is the kind of speculation that got us into the housing bubble. There are two challenges, first it is difficult to spend this equity. A cash out refinance, or selling the property has costs. Second, inflation is not an even thing, it rolls through our economy in waves. Again, invest for cash flow, inflation and tax breaks are the bonus.