Most of us think about investing in terms of making a profit on the money we invest, This is probably the most important consideration when reviewing places to invest your money. But, there is another important component in the profit picture that real estate offers. That component is real estates ability to preserve the purchasing power of your invested dollars and in many cases even increase that purchasing power.
To illustrate this we need to first understand how inflation can impact money saved and it’s ability to work for you in the future. We all see the effects of inflation in our daily lives. I can remember when gas was 15 cents per gallon and now I’m paying over $2.00 for it at times. That’s inflation; we need more dollars to buy the same amount of goods or services. So, what does this have to do with our savings and investments? Well, we invest and save primarily so we will have the money we need for things we want in the future. We realize that the time may come where we can’t work or some catastrophic problem may occur where we need more money than we can earn at work.
The problem with most investments is that all we get from them is a cash return or an increase in value because the investment is worth more than we paid. We refer to the cash return as cash on cash and the increase in value as appreciation. Further, appreciation can come from unknown forces acting on value or just from inflation. We sometimes call the first kind of appreciation speculation. We have all heard of a stock going way up in value because of a new discovery or property jumping in value because of a new company opening a plant nearby. The problem with investments based upon speculation is that many times the new product doesn’t work or that plant never materializes. Then, that bandwagon effect of price increases quickly changes to huge losses.
Since inflation affects most products and services it also affects real estate. This isn’t a good thing if your just getting started but it may be your best friend if you have significant investments in property. Let’s look at how inflation can be a good thing to those who own property. Before we review the numbers we need to revisit leverage. Leverage occurs where you borrow some of the cost of buying an asset, which thereby increases the actual return on the money you have invested. In the stock market it’s called a margin and in real estate it’s just a normal way of buying since most of us can’t afford to pay cash.
As an example let’s assume you are looking at buying a property for $100,000. Let’s look at several possibilities for inflation and their effect on the price of the property. Remember that inflation affects the entire price of the property or any commodity you may want to purchase.
We’ll assume 3 different rates; 1%, 3%, and 5%.
1% inflation on $100,000 = $1,000
3% inflation on $100,000 = $3,000
5% inflation on $100,000 = $5,000
So, if you hold this property for 10 years and inflation is about 3% per year your property will be worth about $130,000 (10 x $3,000 = $30,000 + $100,000). In theory, if you need your money in that 10th year, the $130,000 you get will buy you the same amount of goods or services as the $100,000 would buy when you made the investment. This is the hedge against inflation component. If you need to sell at a bad time in the market this may not happen but, unfortunately, that’s one of the risks of any investment.
Unlike most investments, real estate can be bought with higher leverage and this can be a huge benefit in preserving or even increasing the purchasing power of your invested capital. Let’s look at what can happen in a leveraged real estate purchase. We will assume you purchase that same $100,000 property with a 20% down payment instead of paying cash. Remember you will get the same appreciation as shown in the chart above since inflation affects the value of the asset. So for this example our investment will be $20,000 to buy the property. So we can see the true effect of leverage we need to invest the same amount of capital, $100,000. To illustrate the difference we will assume you therefore purchase 5 properties for $100,000 with 20% down which makes your total investment $100,000 as in the first example. The real difference shows up 10 years later. Our leveraged investor has 5 properties instead of only one for the all cash buyer. To simplify the calculations we will assume there is no payoff of the loans needed to purchase the properties. Here’s how the numbers look. Remember we now have 5 properties worth $130,000 each with loans of only $80,000 each.
TOTAL VALUE OF HOLDINGS 5 x $130,000 = $650,000
TOTAL VALUE OF LOANS 5 x $ 80,000 = $400,000
TOTAL VALUE OF EQUITY $ 250,000
In summary, if you paid all cash and the inflation rate for property was about the same for other commodities, the purchasing power of your investment was preserved. In the leverage example, the purchasing power of your investment was almost doubled. Many might argue that 20% down may be overly aggressive. Our goal is to illustrate how real estate can be a hedge against inflation and even increase the purchasing power of your investment by the use of leverage.
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