Inflation is one of the best allies to real estate investing while also being one of the worst factors impacting the value and purchasing power of the money or cash in our pockets. Historically, the median priced U.S. home has maintained at least the reported annual rates of inflation reported by various governmental agencies and economists. The recent rapidly increasing inflation rates now make real estate investments more important than ever.
Twenty years ago, $20 (U.S.) may have almost filled up a grocery cart. Today, it may buy just a few items at the supermarket, sadly. Since the creation of the Federal Reserve back in 1913, the value of $1 back then may only purchase 2 or 3 cents in 2015. Without the proper balanced portfolio of investments, inflation can destroy wealth faster than create it.
Bloomberg recently reported that the average ticket price at Disneyland (Anaheim, California) in 2015 reached $105. This is a 2,900% increase in ticket prices dating back to 1971 when prices were closer to $3.50 per person. As far back as 1960, ticket prices were as low as $1 to enter the Disneyland gates.
Had someone purchased a home in Anaheim or other parts of Orange County, California back in the 1960s or early 1970s (median priced homes varied between $17,000 and $60,000+ in some regions), then they would have benefited from the annual skyrocketing rates of inflation as opposed to getting crushed by it. Many of these same Orange County, California homes may be worth $500,000 to $1 million dollars plus today thanks to the magical powers of compounding rates of inflation.
Inflationary or Deflationary Economic Cycles
Inflation has been described as an increase in the general level of prices of a certain product in a specific type of currency. Inflation can be measured by taking a “basket of goods,” and then comparing them at different periods of time while adjusting the changes on an annualized basis. There are many different types of measurements of inflation depending upon the “basket of goods” selected.
General inflation measures the value of a currency within a certain nation’s borders, and refers to the rise in the general level of prices. Currency devaluation measures the value of currency fluctuations between different nations. Some related terms associated with inflation are as follows:
* Deflation is a rise in the purchasing power of money, and a corresponding lowering of prices for goods and services. The Fed doesn’t like this economic period of time, and will probably cut short term rates to try to offset it.
* Disinflation refers to the slowing rate of inflation. The Fed may like this type of economic time period, and may stop raising rates at this point in the economic cycle.
* Reflation is the period of time when inflation begins after a long period of deflation. Depending upon the severity of inflation or deflation, the Fed may pause with the rates hikes or gradually begin rate hikes.
* Hyperinflation is rapid inflation without any tendency toward equilibrium. It is inflation which compounds and produces even more inflation. It is when inflation is much greater than consumers’ demand for goods and services. The Fed, and the rest of America, do not typically like this economic period, so they may enact a series of significant rate hikes to slow down these high inflation levels.
Measurements of Inflation
There are many ways to measure inflation. These inflationary measurement descriptions include the following:
* Consumer Price Index (CPI): The Consumer Price Index is the measure of the average change in prices over time for goods and services purchased by households. The Bureau of Labor Statistics reports CPIs for different types of population groups such as wage earners, clerical workers, business professionals and managers, technical workers, self-employed, short-term workers, unemployed individuals, and retirees.
The CPI is an estimate of inflation as experienced by consumers in their daily living expenses. The CPI may factor in the change in the price for food, clothing, rent, fuel costs, transportation expenses, doctor visits, medicine, insurance, and other lifestyle basics which we need in our daily world.
* Producer Price Index (PPI): The Producer Price Index measures the price of goods and services at the wholesale level. There are three types of categories for calculating the PPI. These categories include crude materials, intermediate materials, and finished goods. One of the most important categories for calculating inflation rates is the “finished goods” category. Finished goods are the prices ready for sale to the end user – the consumer. Product prices at the crude or intermediate stages typically may be an early indication of future inflationary or deflationary pressures.
The financial markets tend to focus on the fluctuations of prices for all category types. Food and energy costs are usually excluded as they tend to change quicker than any other goods or services represented within the “core rate.” So, the true annual inflation rates are usually much higher than the reported rates.
* Import and Export Prices: The International Price Program measures the changes in the prices of imports and exports (excluding military goods) between America and the rest of the world.
* Consumer Spending: It measures the spending habits of American consumers. These spending habits include data on daily expenditures, income, and consumers’ many wide-ranging preferences for certain types of goods or services.
How Economic Strategies Affect Inflation Trends
The various governmental and Central Banks’ (e.g., Federal Reserve, Bank of England, etc.) monetary policies across the world are more responsible for our day-to-day inflation concerns than any other factor. These entities have numerous ways of increasing the national money supply. First, the Federal Reserve may cut short term rates to encourage additional consumer spending. They may also increase credit expansion through commercial banks which, in turn, lend more money to private individuals or business owners.
Inflation is an increase in the supply of money at a rate greater than the expansion in the size of the economy. Is there too much money chasing too few products? When demand exceeds the supply of any basic product or service, then the prices typically increase as well.
Low interest rates or demand for U.S. bonds have a significant impact on the supply of money available. If interest rates are too low, then a higher percentage of consumers will probably spend more money. Conversely, if rates are too high, then the demand for goods and services may drop along with their prices.
The Neo-Keynesian Economic Theory has different definitions of the causes of inflation. The first definition is “Demand Pull Inflation,” which describes inflation as being influenced by high demand for GDP (Gross Domestic Product) and low unemployment. Low unemployment usually leads to increased wages.
Another economic definition is “Cost Push Inflation.” The sudden increase in the price of oil is a prime example. Energy costs may be one of the main causes of core inflation. Increased energy costs affect both consumers and businesses.
Another Neo-Keynesian definition is a “Built-In Inflation.” This category is tied to the price/wage spiral. Workers expect to earn more money as time moves forward. Employers are then forced to increase their prices for goods or services to the end consumer to cover their increased worker pay. The result is a “vicious cycle” for inflation trends. Labor costs increase, and then consumer prices follow.
Inflation typically begins with our government’s expansion of our money supply. Some people may benefit while others may not. Individuals on fixed incomes (i.e. retirees), and owners of bonds or cash accounts may suffer substantial losses. Borrowers and owners of real estate may enjoy the gains associated with the increased inflation.
In America, the Fed has control over the issuance of our unbacked currency. Since we went off the gold standard in the 1970s, our U.S. Dollars have been backed by the good faith and credit of the U.S. government instead of by gold. All our government needs to do now when it wants to spend more money is to borrow non-existent money from the Federal Reserve through the issuance of government securities.
The new money issued by the Fed is spent and / or deposited in banks. The banks, in turn, use the new funds as deposit reserves in order to make additional loans to the end consumer. Some of the primary limits to the money supply are the changes in reserve requirements for banks, and debt limits established by Congress.
The Fed and the U.S. Treasury have an important relationship to one another. The Fed purchases bonds from our Treasury on the open market. These bond sales allow the Treasury room to sell more bonds at a later date. The Fed’s purchase of government securities on the open market expands the supply of money and credit.
With a cashier’s check, the Fed pays for the securities with private holdings. The seller (the U.S. Treasury), in turn, deposits the funds in commercial banks. The higher cash balances at commercial banks allow them to increase their cash reserves. With higher cash reserves, banks are able to increase several times the amounts actually deposited by their bank customers by way of our “Fractional Reserve Lending System.”
Ride the Inflation Wave with Real Estate
Per the Consumer Price Index (CPI) inflation calculator, the reported annual rates of inflation has averaged 4% between 1950 and 2000. $1 (U.S.) back in 1950 would have purchased as much as $7.14 in the year 2000 due to a rapidly weakened U.S. Dollar. In recent years, many economists have suggested that the true rates of inflation have averaged closer to 8% to 10%+ per year due to ongoing “Quantitative Easing” monetary strategies in which more money is created “out of thin air” in order to artificially boost asset values for stocks, bonds, mortgages, and real estate.
These consistent ongoing inflation rate increases drastically impact our purchasing power. For example, an automobile purchased this year for $23,000 may cost more than $50,000 twenty years from now. A $100,000 in cash might be worth only $44,000 as the years of inflation will have eroded the value of your dollars.
Investors will pay off their mortgages with cheaper inflated dollars in the future whether it was originally a 50 or a 95%+ percent loan to value mortgage. In addition, their home’s value may be doubling in value every 5 to 20 years partly due to the benefits associated with inflation.
Real estate greatly benefits from years of inflation probably better than any other investment or asset class. Is inflation a friend or a foe to your investment portfolio today? If not, then please rebalance your investment portfolio with more real estate assets as soon as possible since inflation is more likely to increase than decrease in the future.
Author: Rick Tobin
Look for Rick’s ebook on Amazon Kindle: The Credit Crisis Deals: Finding America’s Best Real Estate Bargains.
Rick Tobin has a diversified background in both the Real Estate and Securities fields for the past 25+ years. He has held seven (7) different Real Estate and Securities brokerage licenses to date.
Rick has an extensive background in the financing of residential and commercial properties around the U.S with debt, equity, and mezzanine money. His funding sources have included banks, life insurance companies, REITs (Real Estate Investment Trusts), Equity Funds, and foreign money sources.
You can visit Rick Tobin at RealLoans.com.
Robert B. says
Nice article Rick. Does the CPI reflect my spending habits or experience with price change?