How much money does it cost to go to a movie today?
How much did it cost 10 years ago?
How much it cost 20 years ago?
Much less than today, right?
Ever notice cereal boxes containing less and less cereal over time for the same priced box?
A dollar today does not buy nearly as much as it did just a few years ago. This historic trend is called inflation. The things that you need to buy go up in price and the money you have to buy them goes down in value.
Inflation is Quietly Threatening Your Financial Future
Inflation is one of the greatest enemies of your financial security. It quietly and insidiously attacks and depletes your family’s wealth, savings and buying power, gradually diminishing the lifestyle you can afford to live.
As an intelligent investor, you don’t just need to make money, and you don’t just need to save money…You need to defend that wealth against inflation.
Just as you need to protect your money from someone stealing it or squandering it, you also need it protect it from getting eaten up by inflation.
Nominal Dollars vs. Real Dollars
To understand how this works, we first need to distinguish between "nominal dollars" (which are not adjusted for inflation) and "real dollars" (which are dollars adjusted for inflation).
If you put a chunk of money in a savings account or a CD let’s say, and it returns you 2% interest, then over time you will be making money in nominal dollars (a 2% return in nominal dollars on the money you invested). However, if inflation is rising at more than 2% (as even the most conservative estimates suggest it is), then, in that scenario, you would actually be losing money in real dollars. If inflation is rising at 4% for example, and you are only getting a return of 2%, then inflation is outpacing your nominal dollar return on investment by 2%, which means you are actually losing 2% on your money in real dollars.
How Residential Investment Property Protects You From Inflation
Residential Investment Property is very unique as it is one of the only assets you can buy that is already hedged against inflation. Here is how it works:
- Just like movie prices, home prices increase over time too and rise with inflation. If you own the property, you benefit from increasing home prices.
- As inflation causes construction materials (wood, metal, glass) to increase in price, this drives up the "cost of construction" and the "replacement value" of properties, which in turn contributes to increasing home values.
- Rents rise with inflation too. Leases are typically renewed each year, and rents are typically increased each year to keep pace with inflation.
- If you take out a fixed rate mortgage, then you get to borrow the money in today’s "real dollars" but pay the money back over 30 years in increasingly diminished "nominal dollars" that are worth less than the ones you borrowed. The 30- year mortgage enables you not just to hedge against inflation but actually to benefit from inflation. As an example, let’s say you had taken out a $100,000 fixed rate mortgage in 1983 and made "interest only" payments for 30 years (without paying down any of the principle). In 2013 when it comes due, your loan balance would be the same ($100,000) in nominal dollars, but if we adjust for inflation over that period (using the official rate of inflation based on the consumer price index), you find that the balance you have to pay back in 2013 in real dollars is less than $43,000. What happened to the other $57,000 of real dollars? It was ostensibly paid down by inflation. In other words, the $100,000 of "2013-dollars" you owe are worth less than $43,000 of the "1983-dollars" that you borrowed. So, although you never paid down any of the loan balance in nominal dollars, inflation helped you pay it down in real dollars. You win. Banks lose.
While there are a number of unique benefits to buying and holding residential investment property, the hedge against inflation is one of the least understood, one of the least talked about, and one of the most important wealth-building and wealth-protection benefits to this asset class.
Let us know your thoughts about hedging against inflation in the comments below.