The question is no longer IF inflation is coming, it is WHEN is it coming and HOW bad will it be. Beyond that question, we all want to know how to survive the coming inflation and how inflation will impact real estate.
In this article, we will break down what inflation is and how it impacts the economy. Then, we will see how you can protect yourself from inflation, how to profit from inflation, and how real estate investing will do over the coming years.
What is Inflation?
Inflation is the general increase of prices inside an economy. An easier way to think about it is how the price of some food item may currently be $4 but when you were younger it was only $1. That increase is called inflation.
Inflation is actually quite difficult to measure because there are quite literally millions of prices to track. The cost of milk may vary from one city to another, there are various types of milk, brands, and even organic and non-organic, vitamin D fortified, etc. There are dozens of options just for milk.
Furthermore, if the price of a certain type of milk increases, people may opt to switch to another type. This further complicates the measurement of inflation in just milk. Now, imagine doing this across the millions of different products in the US.
Generally, economists worry most about the prices that consumers pay. They measure this with the Consumer Price Index or CPI.
The CPI consists of a “basket” of goods designed to be a representative sample of the overall purchase that Americans make.
Why the Consumer Price Index is Flawed Measurement
The CPI is obviously not an exact science as there are millions of products that people purchase. Logically thinking through it, no basket of goods could ever accurately measure inflation in an entire economy.
Beyond that, the basket of goods changes yearly as economists add or subtract products that they believe people are purchasing. Additionally, they may substitute a lower quality product if the higher quality product has increased in price.
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Even if they are able to accurately measure the price of all the products in this basket of goods, these subtle manipulations lead to distortions as well.
Imagine the price of your expensive 3-blade razor doubles in price from $2 each to $4 each. Economists at the Bureau of Labor Statistics may decide the average person will no longer purchase these expensive blades and will instead purchase a pack of cheap single-razor blades that cost $2 for 4 blades.
In this example, you actually receive more product for less price, so they may measure a total price decrease. Even if both sets of blades doubled in price, because economists adjusted the basket, it shows no inflation at all.
The Inflation Rate Doesn’t Measure Asset Prices
One of the biggest flaws with CPI is it doesn’t measure asset price changes. It does have some broad measure of “housing” but this isn’t just the cost of property in the US as it includes rental prices.
Other than that, it completely misses the cost of all investment assets such as stocks, commodities, rental property, etc.
There are other measurements of inflation as well from real estate to commodities to other assets. But generally, policymakers seem to care most about CPI. There is one very common alternative measure though.
Producer Price Index
A common alternative to the CPI is the Producer Price Index, or PPI. This measures the cost of all inputs for manufacturers to create their final end product.
This is good for measuring the increase in raw materials or middle-stage production prices such as a circuit board.
How to Protect Yourself From Inflation
Inflation is the enemy of cash. So, to protect yourself from high inflation you want to make sure you have as little cash as possible.
Think about it this way, if you have $100,000 cash in the bank and inflation hits 10% this year, you have lost 10% of it’s value.
While you still have $100,000 nominal US dollars in the bank, in one year it will be able to purchase what you could have purchased today for $90,000.
That’s how holding cash is so detrimental. So, you want to do anything but hold large amounts of cash.
How to Survive Inflation as an Individual
Furthermore, in order to survive inflation, you want to make sure as much money as possible is invested into some asset that will return a higher rate than what you predict inflation to be at.
For example, let’s say you have $100,000 and inflation turns out to be 10%. If you invest that $100k some investment that returns 8%, you still have lost money.
Using the example above, you would need an extra $10,000 in cash to purchase the same amount of goods or services. Your 8% investment gave you $8,000 that year. You’re still shy $2,000 or 2%.
Your “Real Rate of Return” would be -2% whereas your nominal rate of return is 8%. The real rate of return is simply the nominal rate of return minus the inflation rate.
So, you need to find an investment that earns more than the inflation rate if you want to preserve your capital.
How to Deal With Inflation in a Business
Inflation as a business is a bit different to deal with than inflation as an individual as most businesses have to consider the sensitivity of the demand for their goods or products and if they will switch to using the goods or services of a competitor.
Additionally, many goods may be provided on a contract, locking you or your supplier into prices over a longer period of time.
As such, business prices cannot usually move suddenly due to rising costs. In economics we call this phenomena “sticky prices”.
The best thing you can do as a business is lock in the longest term supply contracts you can negotiate, and work to push prices when possible while paying attention to changes in consumer demand.
How to Profit From Inflation Using Real Estate
So far we’ve talked about how to preserve your capital, now it’s time to talk about profiting.
Think about it this way, you survive inflation by beating it with higher returns. But you profit from it by doing the opposite of it.
Since inflation eats cash, it’s bad to hold cash. What’s the opposite of cash?
Let’s say you lock in a long-term $100,000 real estate loan from a bank at a fixed 3.5% interest rate.
In the first year, you would owe around $3,500 in interest payments to keep this house.
But, inflation eats that as well. $3,500 next year is worth only $3,150 in today’s dollars if we have that 10% inflation rate we keep using in the examples.
The following year you would owe another $3,500 in interest payments, but the value of that payment also erodes.
To think about it more simplistically, your parents or grandparents may still be making $250/month payments on the home loan they locked in 25 years ago. Decades ago $250 per month was a large chunk of their salary, but nowadays that’s the cost of a couple of nights out on the town.
How Will Inflation Impact Real Estate
Furthermore, the #1 thing you should purchase before inflation, or hyperinflation hits, is anything that maintains or appreciates in value and can be used as collateral for long-term low-interst rate debt.
The #1 asset in the US that fits these requirements is real estate.
Not only can you benefit from inflation eating your debt, but real estate tends to match or beat inflation over the hundreds of years prices have been tracked.
To really maximize that investment, you can also benefit from rental income, and massive tax benefits as well. With these 4 sources of profit, leveraged with long-term debt, you will not only beat inflation, but profit heavily.