Apartment Real Estate Investing During Inflation and Deflation

I have been buying apartments since 1995 and have been through very different economic cycles including the Savings and Loan bust of the 1990s, the Internet collapse in 2001, and the 2007 housing crisis. So far I have faced and survived all of the challenges of these economic conditions which were beyond my control.

As a very conservative investor, I am always doing my best to evaluate the downside of things beyond my control. When I invest in real estate or any business I do my best to understand the worst case scenario. The thing that most concerns me at this time is inflation and deflation.

When people hear me talk about periods of massive inflation or deflation they suggest I am being negative. But I am not being negative I am merely evaluating the downside. If I can make sense of investing during worst case scenarios then I buy the deal. If I can not then I sit out and wait it out.

If I can make sense of investing during worst case scenarios then I buy the deal.

Runaway inflation terrifies me and deflation even more. Both are extremely complex terms, which very few people seem to really understand. When something is difficult for me to understand I do my best to simplify the topic so I can wrap my head around it. I never trust the professionals more than my own understanding when investing.

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So let’s look at each. First, what happens during periods of high inflation? The purchasing power of the dollar declines. As a result, creditors are getting paid back in dollars that are worth less than they lent out and as a result, they raise interest rates to accommodate. Creditors will demand interest rates a few to several percentage points above the inflation rate.

America printed some 8 trillion dollars in just the last eight years. That is more new money printed in eight years than all other times combined. I am not getting political, I am merely trying to access the impact on my portfolio and future investments. Most suggest this will lead at some point to massive inflation. Supply and demand suggest the more currency available in the marketplace the less that currency is worth and the higher interest rates will go.

So let’s break down the inflation issue in today’s terms. Today inflation is reported by the government at 1.5 to 2%. If you have good credit you can get a loan from the bank at 4 to 5% for a 30-year mortgage. You see the bank wants to make more on their money than inflation. Dollars come back to the lender worth less than they were loaned out at plus the risk.

So what would happen if inflation goes to 10 or 12%? The cost of money from the bank would then have to be 15-20% to get a return on dollars they lend out. This would make new payments on a home mortgage increase over 5X. A $300,000 home has an annual payment of $18,000 a year or $1,500 per month. That payment would explode on a new purchase to $6,000 per month.

People would immediately quit buying homes or the price of homes would have to fall. Home builders would stop building because almost no one will be in the market for a new home as they won’t qualify for the new loan.

As fewer people qualify for a home mortgage, rental demand increases and rents on apartments will go up. Rental property owners with fixed rated mortgages would receive higher income while their mortgage expenses (the largest expense of rental property) would remain constant. Assuming that expenses of operation don’t get out of control and the loan is fixed, the cash flow of the property should improve.

Also, the cost of materials to build new homes and rental product makes both more expensive because the cost of goods and services have also inflated. This should naturally increase the value of your rental property eliminating build of new competing apartment product (an apartment properties owners’ dream).

One word of notice, remember the saver will now be able to earn 10-15% from the bank by simply depositing at the bank in CD’s and/or savings accounts so you will result in fewer transactions in the apartment sector. The banks higher interest paid on savings becomes competition for apartment investing.

Let’s take the other scenario; deflation, which I believe we are more likely headed for than inflation. In times of deflation, there is simply a lack of money to conduct business. The general level of prices in any economy comes down to lack of activity or over-activity.

I have been trying to figure out why we continue to deflate after this massive printing of currency. I think it is because the cash is in the hands of a few and the rest of America is living on credit, which by the way is the new currency. When they finally shut off the credit supply you will continue to get deflation. (That is merely a theory and I would love your input on this.)

When they finally shut off the credit supply you will continue to get deflation.

In times of deflation, there isn’t much money available to buy anything. This lack of money (or credit) creates limits in transactions and this lack forces prices down and that includes real estate prices. From 2007 to 2010, real estate went through a major deflationary period due mostly to overleveraging, bank foreclosures and a lack of credit. Builders and speculators over-leveraged to convert to condos and when things turned bad they just walked.

During that period other commodities such as gold, silver, and oil had major upswings while real estate activity stopped and prices deflated. However, it is important to know the least affected real estate sector was apartments. People have to live somewhere and when they abandoned their homes they became renters. While values came down across all real estate due to foreclosures, the rents on apartments remained mostly stable.

During periods of deflation, income-property has one huge advantage over other assets; the cash-flow continues. Assuming the property was not over-leveraged, you should be able to continue to operate the property while paying down debt.

Even though the value of the rental property drops during a period of deflation, the net rental income should allow you to continue to operate the property and produce at cash flow positive. So while things go through this funk you are paying down your mortgage and receiving cash flow. Most other investments do not do this.

Plus during deflation, the banks won’t have the money to lend for mortgages so you will have fewer renters moving out to buy their own home. Again, your rental income property will come down in value as all things are being deflated but if you weren’t over leveraged you should still have positive cash flow while operating the property and paying down debt.

Assuming the property was not over-leveraged, you should be able to continue to operate the property while paying down debt during deflationary times.

So why not wait until the deflation starts to buy at lower prices? You probably won’t be able to get a loan at that time and if you weren’t out buying during good times I doubt you will have the guts to buy when the world is going to hell.

Because I am a very conservative (coward) when investing I avoid buying rental properties that cater to the high-end renter and try to get in the median range mostly B+ properties in good locations with mid-range rents. One thousand dollar rents should drop less than those at $3,000 when deflation hits.

In summary, multi-family rental properties, apartments, do very well in times of inflation and they have advantages over other investments in times of deflation. Of course, you still have to buy the property right. Overpaying and over-leveraging during periods of massive deflation will make operations impossible. Assume both scenarios when you purchase and if you can withstand periods of either inflation or deflation then go for it.

Assume both scenarios when you purchase and if you can withstand periods of either inflation or deflation then go for it. Regardless, you will still have to operate your property right so take care of your property’s reputation, physical structure, and your tenants.

Do you think we are headed for inflation or deflation? I have a very strong opinion about that which most do not agree but I will leave that for another article.

I hope this helps and I make sure you leave your comments and question below. I love your input.

Be great,

GC

 

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