Inflation and Real Estate

Much has been made of the potential for inflation in the United States lately.  Most of this speculation is due to the enormous budget deficit seen in the US, exacerbated by the multiple stimulus packages enacted during the recent recession as well as the increase in the monetary supply based on actions from the Federal Reserve.  Despite this there are still many out there that don't believe inflation will be a problem in the future.  I will discuss some scenarios I believe are likely to happen and how they will cause inflation to rise.  I will then discuss the implications for real estate in an inflationary environment.

The US has a huge fiscal problem.  Currently, we spend MUCH more than we take in as income (on the order of $1.7 Trillion for 2011).  While there are multiple reasons for this (and it's probably best to not get me started) the fact of the matter is our country is nearing a point where something has to be done as investor confidence is already being shaken.  The total national debt is currently over $14 Trillion dollars and this doesn't even include future obligations for medicare, medicaid and social security (although, over $4T is money the gov't owes itself in the form of social security & medicare trust funds).  In the long run the US has the option of either not making some or all of these payments (defaulting) or it can crank up the printing presses and send out suitcases of cash, mafia style, to all of its creditors.  I suppose the government could also cut spending to below the level of income that was raised, thereby paying off the debt little by little... hahaha, sorry, thought I would check to see if you were paying attention.

Default by the US would be very bad and would be a potentially government ending, revolutionary type moment for our country with panic and blood in the streets.  Obviously, the exact circumstances of the particular default would be of huge importance, but being that as it is, given the two options, the government will lean towards printing more money.  More money in the system, all other things being equal, leads to each dollar being worth less in purchasing power than it was before.

Related to the governments fiscal problems is the Federal Reserves policies regarding the money supply, particularly the responses to the financial crisis, including QE 1 & 2.  Amazingly, with the large amount of money being lent out the money supply has not increased all that dramatically.  Although this might be surprising at first it makes sense when you look at who the recipients of the cheap, or even zero cost money loans are - the banks and other financial institutions.  These organizations have taken the money given to them from the various bail out programs and have piled into government securities.  The yields aren't all that great on government bonds right now but when you are borrowing money at no cost from the government or through demand deposits, then a yield of 1.71% from a 5 year treasury bond isn't that bad.  However, since this money isn't going to loans for individuals or businesses this money isn't being multiplied.  In the not too distant future I predict that banks will decide that by increasing their risk tolerance slightly they will dramatically improve their profitability.  It will take one bank to have an absolutely blowout quarter by offering financing on slightly more liberal terms before everyone else jumps back in.  When this happens you have the multiplier effect of pent up bank balance sheets unleashed - leading to what could be a huge increase in the supply of money, leading to a large devaluation of the dollar in comparison to hard assets.

Obviously, this is a brief explanation of a couple of scenarios that could play out in the near or later future that would trigger inflationary pressure.  Inflation is a topic that has been studied in great detail and there are multiple books that have been written on this single topic.  Nevertheless, if I missed something or if you have a question regarding anything I talked about, leave a comment and I'll do my best to answer you.

I will post a follow up article on why investing in real estate makes sense for anyone who is expecting inflation, or who just wants to hedge against the possibility of inflation.  However, in brief, real estate is considered a hedge because it is a hard asset.  It's value is not tied up in dollars, therefore the change in the value of the dollar is irrelevant because the price of the asset will adjust upwardly as the dollar loses value.  Obviously, there are other factors likely going on at the same time which could affect the value of real estate, namely economic activity at the time but other factors constant, inflation won't effect the value of real estate in real terms.  In nominal terms, the value will increase at the rate of inflation.

Phoenix Area Real Estate Market

I've been noticing a trend in Phoenix area real estate - prices keep going down! 

I'll admit I'm not shocked but I am a little surprised that the market hasn't started to turn the corner yet.  I was looking in the Palm Valley area today at houses and looked at a few properties which are listed on the MLS that would make fantastic rental properties.  One property was a 4/2 and the others were 3/2's.  The most expensive was listed at $105,000 - this in an area with a fantastic school district, great shopping and dining nearby, close to the freeway system and right near Luke Air Force Base. 

The last property I rented out in that area of town had renters calling me the day I put up the sign in the yard - I ended up renting it out within 2 weeks to a great family that is taking great care of the house - and paying on time! (which is always a large plus in my book).  The cash flow on the house is nicely positive even on a 15 year amort loan and that area of town also tends to draw quality family renters who are looking to get into the school district for their kids and settle down.

So going back to the properties I looked at today - and the couple I will investigate further later this week.  If we were to pay market price for a property in this neighborhood (which, of course, we wouldn't) then we are looking at prices of a little over $100k for a 4/2 and $89k for a 3/2 & about 1,600 square.  Using the 3/2 as an example I would legitimately expect to receive $1,200/month in rent on a property like that if it were fixed up nicely to where a family would want to move into it - less fixed up you could rent it out for $1,000 in your sleep.  The 3/2's should be at least $1,100 - at minimum. 

So, for this area of town (paying market prices), assuming you pay cash, then your annual yield would be ($1,200*12)/$89,000 = ~16.2% annually.  Are your CD's or bank interest paying you that?  The stock market has been up but do you realistically expect to make 16.2% on your money?  If you finance this purchase and take advantage of the sub 5% interest rates that are out there now then after your down payment you end up with this cash flow:

Down payment = 25% * 89,000 = $22,250
Assumed fix up cost (Just a guess - I haven't actually seen inside yet) = $10,000
Total cost up front - $32,250

Monthly mortgage payment on the remaining $66,750 balance, assuming a 30 year amortized loan at 5% interest, compounded monthly = $358.33
Average taxes + insurance = $150
So, monthly cash flow = $1,200 - (358.33+150) = $691.67 monthly cash flow
Yield = ($691.67*12)/$32,250 = 25.7% 

Oh, and by the way if financed that doesn't include the fact that the renter is paying off your mortgage.  It also doesn't take into account any appreciation - which its anyone's guess as to when the market will start posting increases but given Phoenix's history of boom and bust I wouldn't at all be surprised to see another strong market back in the valley of the sun - if not within 5 years, at least within 10.