Let's take a moment to review the effect of economic cycles on investments. Today with a low inflation rate, low interest rates, and booming real estate markets, it's difficult to remember that markets move in cycles. Good markets are followed by inflated markets where development and construction create too much product, so sales slow down. Unable to sell their product, builders go broke, creating depressed markets. Entrepreneurs rush in to buy on the cheap, creating more demand. This makes sales pick up, and we're back to good markets.
This is a sort of chicken and egg situation in which one phenomenon creates the next. The business cycle results from the responses of millions of businesses to movements of industry and people, demographics, trade relations, technological innovation, and government manipulation of the economy.
In 1986, political fiddling with the Internal Revenue Code altered the relative advantages of stocks over investment, so stocks soared and real estate crashed all over the country. Bush wanted to repay his Texas supporters, so he came up with the RTC that wiped out a trillion dollars of real estate loans, causing even more S&Ls to fail. Economic phenomena can be confusing, so let's get our terminology straight:
INFLATION: Prices and interest rates are rising because of increased demand for relatively fewer goods and services. The purchasing power of the dollar declines relative to prices. Everything seems more expensive. Leveraged consumers and investors who have used fixed rate financing are winners, and their lenders are losers as loans are paid back in depreciated dollars. Borrowers who have signed personally on variable rate loans soon find themselves unable to meet rising interest rates, but those who hold indexed mortgages see their incomes rising at the inflation rate.
Here's an example: In the late 1970s, Jimmy Carter flooded the credit markets: with easy money that found its way into increased wages among wage earners, but without a corresponding increase in their productivity. Putting more money into the hands of consumers spurred demand. Too many dollars chasing relatively fewer goods caused high inflation during the late 1970s. All real estate was booming, especially housing. The Bush administration has been pouring $ trillions into the economy.
As you might have surmised, financial terms have more to do with pricing than any other factor. When real estate is “booming” it is invariably the result of the availability of mortgage loans at low real and nominal interest rates from many lenders. The real estate boom of the late 1990s was fueled by low nominal interest rates and historically low income tax rates, but the boom of the late 1970s was driven by low real interest rates. Let me explain:
The interest rate you pay on a mortgage loan represents a certain number of dollars that you pay to “rent” money from a lender to buy real estate. The nominal rate is stated on the Promissory Note. But this isn't necessarily the “real” rate. “Real” interest rates are arrived at by comparing the nominal rate to the rate of inflation and current tax rates. In 2002, with inflation creeping up to around 2%, nominal fixed mortgage interest rates are about 6% or so, but in real terms, this boils down to a real rate of 4%. This is a high rate of real interest by 1980 standards when real interest rates were actually negative when compared to the rate of inflation.
What do taxes and inflation have to do with interest rates? The dollars that you spend on mortgage interest must first be earned, and taxed, before they can be sent in on your payments. In some instances, the interest you pay can be deducted from taxable wages. When that happens, the higher the income tax rates that you pay on earned income, the less real interest you will be paying.
Here's why: Today, most people are in the 28% income tax bracket. Back in the 1970s income could be taxed in the 70% bracket. In so many words, the IRS paid 70 cents of every dollar of deductible interest a person in the 70% bracket paid. So, if the nominal rate of interest were 10%, the government would be paying 7% and the borrower would be paying a real rate of 3%. You may recall that one of the biggest real estate booms in history occurred during these times. But, real interest rates in the late 1970s were even lower, in fact negative.
The other factor that affects the true rate of interest is the economic “deflator” which measures deterioration in the purchase power of the dollar. In so many words, it measures the rate of inflation. If you were to borrow $100,000 in dollars to purchase a house appraised at $100,000 fair market value, in the absence of inflation, you'd pay $100,000 back over time plus interest. But, if the dollars you paid this loan back with were losing purchasing power at a 10% annual rate, the lender would be losing money at the rate of inflation. Meanwhile, the appraised fair market value of your $100,000 house would be rising at 10% per year. Plus, the real rate of interest would be dropping at the rate of inflation each year.
In the double digit inflation of late 1970s, house prices in many locations were rising at 2% or more each month, or 24% per year while nominal FHA mortgage interest rates rose as high as 17.5% in many areas. When you can borrow money at a rate even as high as 17.5% to finance a house that is appreciating at 24%, you're paying 6.5% less than the rate at which you're making money. Moreover, the 17.5% interest rate is also effectively being reduced by the inflation rate as you pay interest with dollars that are worth less and less.
Today the income tax deductible 6% mortgage interest rate is offset by a top rate of 38.6% versus 70% in the 1970s. In the current real estate boom, despite amazing price increases in certain “bubble” markets, in many areas of the United States, price appreciation hovers at a point that's less than the price increases of the 1970s. Figured this way, when measured against the rate of inflation, fixed rate mortgage interest in some areas today is over twice as expensive as it was in the 1970s.
This panics the stock and bond markets. Apprehensive fund managers and investors cash in their chips and start looking for alternative investments. This brings up the question; what market can absorb hundreds of billions of dollars quickly when investors are trying to get out of stocks and bonds? Only real estate and precious metals!
We last saw this phenomenon in the late 1970s and early 1980s when Gold prices rose to $850 an ounce, Silver rose to $50 an ounce, and leveraged single family houses outperformed them both. In some areas, houses were rising at the rate of 3% per month, creating thousands of real estate millionaires at the expense of stock and bond investors as millions of people tried to convert their investment portfolios to tangible real estate assets.
We're poised to see this happen again. And that's the reason the stock and bond markets will be a fourth source of real estate investment capital. The trick is going to be to find ways to get the word out about single family homes to jittery stock market investors, pension plan trustees, and IRA Custodians
From Jack Miller's emanual CREATING WEALTH WITH HOUSES.
