What Happens To Real Estate When Inflation Goes Up?

What do you suppose will happen to the financial markets when the public finally catches on to the fact that the total federal budget is just a big exercise in cooking the books just like our Indian Chief who carved his own wampum shell. The Social Security trust fund is just a book entry which shows what the government owes those whose wages they’ve been milking through payroll taxes. There’s no money in it; only unsalable government bonds. This can have ominous portents.

What would you do, knowing that all of your intangible wealth consisted of tiny electrical impulses stored inside the memory of a bank or brokerage or money market fund’s computers, when you perceived that its value was held up more by public confidence than anything else? Would you head for real estate, gems, collectibles, gold and silver bullion and coins as millions of investors did in 1978 and 1979?  In 2008, investors stampeded out of the securities markets and all those 401K accounts were reduced to pennies on the dollar.

Do you remember what happened to the Dow Jones Industrial average by the time Ronald Reagan (Republican) replaced Jimmy Carter? It was about 650, less than one tenth of 1997 levels.  That’s when I bought my gold coins. And when I began to face real competition buying houses.  Everyone wanted to get into real estate and away from intangible assets

What became of the lenders? Remember, up until that time, they had millions of dollars locked up in loan portfolios with interest rates that ranged from about 5% to 11%. In 1980, FHA rates were about 17.5% and private lenders were charging 22% for fixed rate loans. Second mortgage ‘Paper’ was being sold to yield 45%.

What about the situation today is fundamentally different from the past that would make the business cycle not repeat itself? There are several factors which make the timing of the business cycle difficult. One of these is the instant response that the computer trading programs can generate at the first sign of the slightest hint of economic trouble. Like someone touching a hot stove, investor reaction can be instantaneous. We’re seeing two billion shares routinely traded on exchanges in a single day in these anxious times.

The banking industry came up with variable rate loans with introductory teaser rates that attracted gullible borrowers.  Thus they hoped to avoid being trapped in another inflationary down-draft in portfolio values.  Then, like any respectable bookie does when the risks are too great to bear, they laid off their long-term mortgage paper onto REITs, Freddie Mac, Fannie Mae, and Ginnie Mae.  These parties in turn sliced and diced their loans into tiny pieces that they sold as mortgage-backed securities on the stock market to Hedge Funds who raised the money by issuing shares backed by these pieces of mortgages.

Marketable securities are issued to represent this paper portfolio and sold into the same stock market where so many people, pension plans, 401Ks, IRAs, etc. are holding their supposed wealth.  This house of cards has already started to tumble down.  Despite all the efforts of government to shore up this failing financial pyramid, it continues to crumble.

The government realizes the precariousness of the knife’s edge on which the economy is balanced. That’s why there are program trading limits and emergency powers in place to try to limit the damage. But these programs overlook one tiny factor. We live in a global fishbowl. Americans no longer control their destines. While government can impose trading limits and shut our markets down from time to time, those in Singapore, Tokyo, London, and Paris will be where savvy investors will be dumping their shares and currency.

Inflation Robs Savers By Devaluation of the Currency

Remember, we started all of this talking about money and currency.  Our current economy is in such a precarious state that we dare not borrow more for fear of driving up interest rates that would founder business.  Like our first Indian Chief, government dares not impose higher taxes on already strapped taxpayers to bail out State and local governments.  If it did, it would be dismissed in 2012 in the same way that it was dismissed in the bloodbath of 1994.   If our government starts printing money, all the foreigners who have bought our T-Bills will want out. In order to reinvest their funds outside the U.S., they’ll have to buy other currencies. Suddenly, there will be hundreds of billions of dollars for sale at the same time. Supply and demand will kick in and the dollar will drop like a rock while all the other currencies spike against it.

As a result, Americans are going to see astronomical price increases when they try to use devaluated dollars to buy parts for Sony TV sets, Toyotas, and clothing made in Asia. Or automobiles, equipment, oil, and industrial products from Europe. Or real estate in the USA. We’re going to become the world’s cheap labor pool, and those who bet their whole net worth on intangible financial assets will be happy to be able to be working.

Perhaps we can take a look at what happened in Argentina and Brazil in the 80s; or in Germany in the early 20s; or in China in the late 40s; or in Israel for decades; when the public stopped ‘buying’ money with their goods.

The first victim was the political process as it had previously been known. In almost every instance where the full faith and credit of their government’s currency comes into question, the citizens replace it. Sometimes a military junta takes over.  Or there’s chaos. Sometimes a revolution.

Indexing Intangible Investments is the Government’s Defense

Sometimes to ward off all these problems, the government indexes everything to the inflation rate, including taxes. When prices over a broad array of goods and services are indexed to the inflation rate, it’s an admission by government that it intends to do nothing about curbing inflation. We’re talking about big time hyper-inflation of thousands of percentage points a year that robs virtually every financial asset of value.

I can remember the headlines in a Buenos Aires newspaper that heralded the economic break-through that brought the annual inflation rate down to a mere 350%. You may remember that most of that time Argentina was being governed by a group of Army Generals through something other than the democratic process.

On a visit to Buenas Aires, I talked to both the President of a private investment bank and his secretary in Argentina about the practical aspects of dealing with long term spiraling inflation that leap-frogged each year for 30 years.

At the top of the totem pole, the banker held his wealth outside the country in Swiss Franks or in foreign investments denominated Swiss’ gold-backed currency.  His purchasing power inside Argentina increased with every tick upward of inflation.

After political power was returned to the people and democratically chosen leaders, the Argentine currency was pegged to the U.S. dollar (which was stable at that time). Inflation dropped almost immediately. Then the banker used the wealth accumulated in Switzerland to snap up millions of acres of forest land and natural resources; real estate, not financial assets.  Today, for political reasons, Argentina has once again decoupled its currency from the dollar, and inflation is soaring again.  It simply makes the banker richer.

What about his secretary? At the bottom of the totem pole, wealth preservation boils down to finding a way to survive with plummeting purchasing power. Computerized cash registers in every store were programmed to reflect the inflation rate. The customer just ahead of you in line might pay far less than you when buying essentially the same products.

Workers in factories would spend their lunch hours scurrying from bank to bank seeking the best daily rate of interest. Weekly pay was deposited directly into the selected bank accounts, and spent immediately on durable goods and food.

Real estate was a mainstay of the economic defenses of a typical family. The private houses people had bought and paid off prior to the advent of indexing were like gold. They accelerated in value every day. But those that had bought real estate with high leverage, even with fixed rate financing, didn’t get the benefit of price inflation because their loan balances were going up as fast as the house prices.

What can we deduce from all of this:

1.    When you exchange tangible assets for intangible assets, you are really trading something real for something that has been promised by someone who may not keep that promises because of politics or the economy.

2.    While ordinary financial assets such as stocks, bonds, notes, and similar financial assets are fine in normal times, they don’t do well anytime that the economy swerves toward either prolonged depression or high inflation.

3.    In a recession, where high numbers of people are unable to earn a living, there aren’t very many buyers in either financial or real estate markets. Virtually all non-income-producing assets lose their value while those with a solid income stream gain value.  That often means that landlords have to find ways for tenants to “double up” in a single family house in order to keep rents flowing in.  On the other hand, the landscape is littered with financial promises in the form of notes, bonds, stocks, mortgages and pension plans that are wiped out by the combination of inflation and bankruptcy.

In the 1930s in America, of all the financial obligations that people invested in, insurance annuities did the best job of providing the income that had been promised. That was primarily because government didn’t resort to inflation to pay for social programs, and the country sank to the Great Depression.  Free and clear residential rental properties ranging from residential hotels to flophouses to boarding houses to rental houses to trailers all did fairly well, albeit at very low rental rates.

Even when mortgage rates were only 2%, rents weren’t enough to cover the payments. Remember that one of the highest paying investments was called Postal Savings which paid 1 %. T-Bill rates fell to .25%.  Today they are paying little more.

4.    During periods of high inflation, interest rates rise to keep pace with the diminishing purchasing power of the currency; but they always lag behind a little. As a result, lenders’ real yields, measured as the difference between after-tax earnings and the inflation rate, chronically fall behind those of the buyers.  They will continue to do this so long as buyers “rent” borrowed money at fixed interest rates to invest in assets that match or exceed the inflation rate. Rental real estate, safely leveraged with fixed rate debt, is an ideal vehicle to own when inflation rears its ugly head.

Conversely, investment in fixed rate mortgages and bonds, or stocks present the worst of all worlds; losing value when government inflates, and also losing value when government causes a recession or depression.

5.    The trouble is, that it’s hard to get out of a losing investment without taking a real financial bath once the public perceives the situation. The vaunted liquidity that financial markets use to induce people to invest in them is illusory. Anytime a financial panic causes millions of sellers to stampede into trying to sell at the same time, it scares off most buyers, and liquidity disappears, causing prices to plummet off the precipice.

6.    In a deflationary scenario, cash is king; along with other extremely liquid assets such as 90 day T-Bills.  Cash can be used to buy tangible assets at low prices.  In an inflationary scenario, what’s far more important than cash is an indexed income stream that can be adjusted frequently enough to earn a market yield defined by real increases in its after-tax purchasing power.

Single Family Houses Are a Double-Edged Hedge

This brings us back to our definition of money. Something that maintains its value during good times and bad over a long period of time, and something that is readily acceptable as a medium of exchange for which our investment alternatives to see if we can’t meet these objectives by devising our own private investment currency.

The real estate business embodies the opportunities and disabilities that are inherent in both tangible and intangible assets.  On the one hand, it is totally dependent upon the availability of credit to survive, and on the other hand, real estate assets are a classic hedge against inflation.

Regardless whether a person is a lender or a borrower, a strategy aimed at building long term financial security must be built on the twin foundations of maintaining after-tax purchasing power of income, and a mode of financing that will enhance the net market value of portfolio assets over time.

How should we approach this challenge. Just as those erstwhile entrepreneurs of Yap created their own money, let’s think of our own assets as if they too were a form private currency. Because I’m a product of the real estate industry, I’ll use single family houses and mortgages to illustrate some insights and strategies.

When I was 22 years old some friends and I built a small single family house from scratch using salvaged materials.  It was for a co-worker to live in.  Our total cost was under $3000 including a $65 lot.  No financing was used at all. He lived in it for a few years, then moved on and rented it out.  Forty years later the property was bought along with other lots and cleared for a strip mall.  At that time, the free and clear house was bringing in $575 per month rent and the owner was paid $30,000 for the lot.  There’s no point in trying to figure the yield.  Let’s just say that it was enough.

That’s why I don’t think that it’s all that far a stretch to look at a single family house we built in much the same light that the Yap looked at the stone he’d carved. No doubt both were a store of value. But, how are single family houses a medium of exchange?

You’ve been delivered the slow curve, now here’s the fastball. During times when both cash and credit are in short supply, people turn to barter.  Or to real estate Exchanging. Ask around among professionals and you’ll find that a decent free and clear house priced in the middle of the market is as tradable a commodity as there is in the market.

Why? Because it has extremely wide market acceptance (doesn’t that sound like one of the attributes of money?) Moreover, when occupied by its owners, its equity is among the easiest of all real estate to convert to cash through financing.  That’s true today in November 2008 when financial markets are in complete disarray.  Buyers are still able to get 30 year 6+% fixed rate loans to buy personal residences.  I know because I’m selling these houses to them.

Generally speaking, over the span of recorded history, a single family dwelling has maintained its value in terms of purchasing power when it has been converted to cash through a sale or via borrowing. The real estate cycle is roughly 9 years long.  Surely, there have been periods when people who bought at the top of the market and who were forced to sell for financial or personal reasons lost purchasing power when they sold their homes.  But, that hasn’t happened very often to very many owner-occupants.  For the most part, those who bought houses with fixed rate financing to live in have not lost these homes.  The real estate crash was mostly populated by people who refinanced perfection good homes with ruinous financing, or by speculators who paid too much for the property and paid too much for financing.

Even the cries of California real estate investors stemmed less from the loss of their equity value in property they’d bought than the fact that they’d borrowed out their equity only to have the value of the house fall below the new loans they’d placed on them. Had they simply sold their houses to capture their appreciated equity rather than mortgaging them, by and large, they’d have made a profit.

When depression looms, people still pay rent because they have very few alternatives. I was a depression kid in the 1930s. We lived in rented houses. Admittedly, the rents were ridiculously low.  In 1938, my father rented the personal residence of Florida Governor Fred Cone while he lived in the Governor’s Mansion in Tallahassee. The rent for this 2000 square foot home was $30 per month. Or about one week’s wages.

Rents seem to parallel the value of a week’s wages just about everywhere. When both parents work, they move into larger houses, and the rents again just about consume their combined wages prorated for one week. In other words, having a free and clear house is tantamount to having one person go out and earn a paycheck one week out of each month and to use it to pay the rent.  You can see that owning 4 houses is almost like having another wage earner in the family. This isn’t a bad idea when people are being laid off.

Owning 10 free and clear houses would provide both financial security in good times and bad and as good a source of retirement income as most people ever see. That would be the income-equivalent of both spouses continuing to work full time at their regular jobs and getting the wages from another party working part time.  Ten houses would require just enough effort to keep their owners from being bored (and boring) retirees as they dealt with the properties and collected the rents.

Where does the rent come from if people are out of work? It comes out of the first money they earn, even ahead of food, when times are tough. When people can’t pay rent, they can usually work it out. I’ve had roofs put on, houses painted, interiors refurbished, paneling and dry-wall hung, plumbing revamped, and air conditioners installed by tenants in lieu of rent.

As a kid, during the depression, just about the only actual cash money spent was for rent and medical care. Without any social safety nets or government payments, every family had to learn to be self-sufficient. My mother made shirts and skirts out of patterned feed bags which were in vogue back then. Nothing was discarded. You might say that we operated an in-house family thrift store. We all used each other’s hand-me-downs. When the last kid outgrew them, clothes were passed on to the neighbors.

We all picked berries and fruit which my mother canned; raised garden vegetables and chickens; “condominiamized” a cow with a neighbor by providing all its feed for half of its milk. The whole family could go to the movies for under a dollar. On “bank nights”, they gave away dishes to lucky ticket holders. Every member of the family did odd jobs at every opportunity to raise money with which to pay the rent, because, without a place to live, the family would have been destroyed.

The solution to paying for housing in the 30s wasn’t that much different from the way people in intervening recessions since then have done it. They doubled up. My family took in boarders who paid rent and took their meals with the family. During economic slow downs, as a Landlord, I look the other way when tenants double up.

I’ve found that I can raise rents even during hard times when two families are paying them. The property damage that too many people in a house cause is far less than the financial damage that can be caused by a single family that can’t pay the rent.

All the survival strategies I learned as a small child are hard to envision in today’s welfare society that coddles both the improvident yuppies who default on student loans, car loans, and file bankruptcy to wipe out consumer debt.  It also retains the loyalty of indigents by taxing the earnings of the working class, giving the money to those who won’t support themselves.  But let the government money dry up and you’ll see a roaring return to the work ethic.

So what’s the bottom line to all of this?

1.    Wealth must be denominated in money or currency that can survive the tests of time, political upheaval, or economic gyrations.

2.    While intangible financial assets usually offer easy returns with great liquidity, they are vulnerable to perceived changes in the interest rates, taxes and/or inflation.

3.     The value of tangible assets lies in their permeability, but they are often illiquid. Thus, when trying to build a financial fortress, income-producing real estate can’t be beat.

4.      Of all the income producing real estate, the single family house offers the most benefits. These include diversification, wide demand, easy financing, and reliability of income either in the form of currency or barter.

5.       Government promises can be modified or withdrawn without warning, so should be viewed with a high degree of skepticism, this is particularly true of those who depend upon government-subsidized rents from HUD Section 8 and similar programs.

Your ultimate survival is going to depend upon the preparations you have made in acquiring property and marketable skills for yourself and for your family. I hope the above quick tour of money will give you some insights to ponder, and that I can continue to provide help through the other publications I write.

From Jack Miller’s Recorded Seminare MONEY MATTERS...