Leveraged Inflation - A nice upside or am I crazy?

Question

I've been modeling out tons of deals over the past month and refining my model (I'm a newbie and have made a couple offers, but nothing that has stuck yet - fingers crossed on one I'm negotiating price with now). I had an interesting scenario that I've been playing with and have temporarily named it "leveraged inflation increase" until I find out whether there is an existing term out there.

Here's how it works - Assuming your property is in a market where rents and all of your expenses generally rise with inflation, one thing doesn't change from year to year, which is your mortgage payment. When it first occurred to me and I started modeling I was expecting this to be a slight boost to my cash flow each year by maybe 1-2%, but turns out the year-over-year cash flow increase above the inflation-adjusted cash flow from the prior year is much larger and keeps growing from year to year! Huh??

Example (without getting into the weeds on my model):

Year 1 cash flow is $10,000 and inflation is 3% for all years. With 25% down and about 45% expenses (as a % of gross rents)

Year 2 cash flow is $10,525, but the inflation adjusted $10k is just $10,350, so a boost of $165 or 1.25% additional increase in cash flows after factoring in 3% inflation. No big deal.

Year 3 cash flow is $11,000 on the again inflation adjusted $10,670, so a boost of $330 or 2.63%.

Year 4 cash flow is $11,500 on the again inflation adjusted $10,990, so a boost of $510 or 3.79%.

Year 5 cash flow is $12,000 on the again inflation adjusted $11,320, so a boost of $690 or 4.85%.

Year 6 cash flow is $12,540 on the again inflation adjusted $11,660, so a boost of $880 or 5.82%.... See where this is going?

Not a huge deal, but adds up when you're modeling out future cash flows. Am I way too in the weeds? Has anyone seen this occurrence or have a name for it?

Thanks for bearing with me...

Christopher Brainard · Answer

@Mike McNeil-Leier

I bet that looks amazing in a spreadsheet, but probably irrelevant to the real world. As you gain experience in the real estate world, you will find out that each property in each market has different levers affecting it. Rents go up and down, Values go up and down, and the Macro Real Estate Market has its own cycle. The majority of your wealth will be made by buying the right property, at the right location, at the right price and exiting that property under optimal conditions. Being a landlord is all about having someone else buy you a house and you for the privilege - your job as the investor is to make sure its the right house.

-Christopher

Kevin Grove · Answer

Mike,

Keith Weinhold of Get Rich Education calls this phenomenon "inflation-hedge" (see #5 below). It may be a small benefit, but all the small benefits add up.

The 5 Ways You're Paid In Real Estate Investing

by Keith Weinhold

1. Appreciation. Your 
property appreciates from $100,000 to $106,000, commensurate with real 
estate’s historic appreciation rate of 6%. Your $6,000 gain is based on 
your down payment of just $20,000. That magic of leverage means your 
return is 30%.

2. Cash Flow. Your
 rent income minus all the monthly expenses (mortgage, property tax, 
insurance, property manager, repairs, vacancy, etc.) leaves you with 
$150 of residual income. That $1,800 divided by your $20,000 down 
payment is the portion we call the Cash-On-Cash Return. That’s another 9%.

3. Loan Paydown.
 Unlike your own home where you pay this, your tenant pays the monthly 
principal portion of your $80,000 loan on this property! At a 5% 
interest rate on a thirty year mortgage, that’s $1,176 that the tenant 
pays down for you annually. Divided by your $20,000 of 
“skin-in-the-game” means that’s another return for you: another 6%.

4. Tax Benefit.
 We’re talking about both the mortgage interest deduction and something 
called “depreciation” that you can typically use as a tax write-off 
against your income. This means you typically don’t even pay tax on all 
of your rent income. Your return here can be hard to measure because 
it’s based on your situation, but we’ll conservatively call this 
investment tailwind another 3%.

5. Inflation-Hedge.
 This fifth way is one that even some advanced investors fail to 
consider. Just like inflation erodes the value of your lump of savings, 
it erodes the weight of your mortgage debt balance just the same. Your 
$80,000 loan today has its “drag” diluted over time as more & more 
dollars circulate in an economy. It gets easier to “pay back.” We’ll 
call this benefit a return of another 3%.

Russell Brazil · Answer

And imagine what happens in location where your rents and asset value grows at rates far exceeding the inflation rate. Thats how those of us in certain metro areas grow very wealthy in short periods of time.

Joe Villeneuve · Answer

I can tell you where this is going...nowhere.  You need to focus on the $$$$ on greatly reduce use of %%%% in your analysis.

Leveraged Inflation - A nice upside or am I crazy?

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