Where and how you place your investment capital is critical, especially in an inflationary market.
What do you think of the current inflation rate?
I start every conversation with investors with this question. I often hear a “2%-3%” response.
It is a popular number in recent years, and is now a very long way from the “official” numbers.
Let’s take a look at how inflation is measured.
PCE and CPI
The Personal Consumption Expenditure Price Index (PCE) and the Consumer Price Index (CPI) are the two most common inflation indicators. Published data from the Federal Reserve puts the CPI at 6.8% at the time of writing.
Each indicator is very specific in its measurement and concentration.
The Consumer Price Index is a statistical estimate created using the prices of a sample of items whose prices are collected periodically. The PCE price index is a narrower measure. It looks at the changing prices of goods and services purchased by American consumers. It is similar to the Bureau of Labor Statistics’ Consumer Price Index for urban consumers. Each of these inflation indicators refers to specific items that are measured and tracked, most of which can be controlled through the Federal Reserve’s monetary policy.
However, if you look at inflation as decrease in purchasing power, Other economic indicators, in my opinion, better illustrate the real change in the cost of living for the average American. They consider a wide range of expenses that affect consumers and influence how location affects expenses. For example, the Personal Consumption Expenditure Index attempts to identify underlying inflation trends by excluding two categories – food and energy. However, food and energy are important necessities for all consumers.
Take a look at John Williams’ www.shadowstats.com and Ed Butowsky’s www.chapwoodindex.com for comprehensive inflation data. Your eyes will be opened to the ‘wizard behind the curtain’, and you will better understand how critical investment capital is.
Why real estate investors benefit from inflation
A real estate investor with the right leverage is one of the few who reap the most benefit from inflation.
Many have argued that the erosion of the dollar due to inflation reduces debt – and they are right – but I have not found anyone offering more than theoretical picks on the subject. To provide more meaningful data on this topic, I partnered with Dr. John Abernathy of Kennesaw State University’s Department of Accountancy to provide calculated evidence of real “debt erosion.”
Understanding “Good Debt” vs. “Bad Debt”
Before we get any deeper, let’s get into the idea of debt. We are all familiar with the concepts of ‘good debt’ and ‘bad debt’.
I wouldn’t properly consider leveraged real estate as “debt” at all. Debt is something that hangs above one’s head as a liability, and it follows the person until the debt is satisfied – with only the person’s resources that can be withdrawn from repayment. With real estate with the right leverage, the investor has what could be considered less liability in the transaction. Certainly, the investor should guarantee repayment, but the interest should be considered as an intermediary between those who issued the funds for financing and those who use the asset for their personal use.
Metrics such as “cash for cash return” and “cap rate” are often presented as ways to analyze a real estate investment’s potential as a good investment. These are good metrics, but they do not provide the full view of how a real estate investor will benefit fully.
Calculations like this are a way of determining, in a fast-paced world, whether the opportunity presented via the initial form is worth delving deeper into. When digging into it, I prefer to take a look at the attractiveness of the property to a potential tenant. Additionally, will it be the type that will remain reasonably occupied for the duration of my property? Finally, is it a market where I can raise rents?
If a real estate investor, as the CEO of their real estate investment business, is able to make the right decision about who to work with in acquisition, management, maintenance and financing, it can have a more significant outcome than what is presented on the initial joint format.
crush numbers
Using some baseline numbers, let’s explore what those returns could be. Let’s use a $150,000 acquisition price, with a 20% depreciation, 0.8% rent-to-value ratio, a 30-year fixed loan, and a cash flow of $200 per month. Each market is different, and each outcome has its own variances, so these numbers are for illustrative purposes only.
So, suppose a real estate investor has done his job, picked the right people to work with, selected the right business (real estate) to buy, and kept it reasonably rented for the life of the property. Who pays the financing?
If you say, “the tenant,” you’re right. Over the life of this 30-year loan, the tenant’s rent payments will be used to meet the terms of the financing.
Let’s do the actual math. The simplest way to find out what kind of return was received only for amortization is to calculate the amount of financing itself. On $150,000, 80% equals $120,000. Dividing $120,000 by 30 (the number of years to be paid), gives you $4,000. This means that renters will pay $4,000 annually in average financing over 30 years. (Yes, I realize the depreciation schedule isn’t quite like this, but remember we’re aiming for simplicity with this illustration.) Now, divide the $4,000 by the investor’s initial investment, which will count as $35,500 (20% is less than $150,000, plus $5,500 in the lender’s closing costs, property, appraisal, inspection, etc.)
If you divide the average increase of $4,000 by the initial investment of $35,500, you find that the $4,000 is an average increase of 11% in the initial investment year after year for 30 years. This investment has already yielded an interesting return, and we still have to discuss the cash flows, tax benefits or inflation hedge.
Given the cash flow, we’ve identified $200 per month as potential income for a $150,000 property. Many may avoid this investment because the potential income is too low and may not meet the “cash for cash” return requirements they set for themselves. However, let’s see if we can find a utility for a property that may have been overlooked in the past.
If such property is available, and we feel confident that we can keep tenants and raise rents as well, we should take the time to evaluate that growth over time. We shouldn’t get caught up in the first two years of cash flow. I’ve seen myopia derail a lot.
Let’s take a closer look. In the first year, renting $1,200 per month (0.8 rent to value ratio/RTVR) will save $200 per month in cash flow. The property was purchased in part due to the ability to increase rents. However, what is the average rent increasing these days? Double-digit percentages are quoted across the US – I’ve seen averages posted at 10%. For the purpose of this example, let’s reduce this number to a 3% average rent increase for the foreseeable future for this property.
So 3% of $1,200 is $36 – nothing earth-shattering. This kind of increase does not excite the real estate investor, nor does it freak out the tenant. This means that in the second year, the rent becomes $1,236, which makes the cash flow $236. Do quick calculations and find that this represents an 18% growth in your cash flow. This is complex growth. Every time you raise your base rent by 3%, you will likely get an 18% growth in cash flow. This is very exciting.
But that’s not the best part. Does the lender get an increase in loan repayments to keep up with inflation as the investor does? No, the loan is a fixed term loan of 30 years. In fact, inflation is rampant and devalues the dollar very quickly causing the lender to experience a compound decrease in repayment.
Let’s use a 6% rate to calculate the numbers. We’re not that high right now, but let’s beat that equation a little bit. Paying $719.46 per month for 30 years, we have a total of $259,005.83 of principal and interest over 30 years. But remember that every time a payment is made in our high inflation environment, the dollar spent is less valuable. Calculate every dollar each year for 30 years using the depreciation calculator included in the QJO Investment Tool app, which can be downloaded from your App Store. You will see that the value of those collective dollars is $98,050.61. The investor repaid 81% of the initial balance in real dollar terms.
Please visit www.aaronbchapman.com to schedule an appointment to discuss this topic in more detail. Also visit the Loan Process tab for more information about financing with my team and the application.
Aaron Chapman is a veteran of the financial industry, which he entered in 1997, after experience in mining, operating heavy equipment, welding and driving long distance trucks.
Since entering the finance industry, his clients have ranged from those buying their first home, building their dream home, or investing in multiple properties for long-term cash flow. It is currently number 14 in an industry with over 300,000 licensed loan originators closing over 100 transactions per month. Chapman’s expertise helps real estate entrepreneurs navigate the difficult parts of building a real estate business.
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