Inflation-Induced Debt Destruction
So learning about real estate also means learning about economics. Micro and macro. I am sorry to tell you this if these were your least favorite subjects in school. They will probably become more interesting now that they can help you to build wealth for your family.
The term “Inflation-Induced Debt Destruction” is the creation of Jason Hartman who has a good podcast on real estate investing. This term helps to understand the potential value of debt in a real estate strategy. It means that the debt is being eliminated by inflation. Inflation is the economic force that increases prices and devalues dollars.
Imagine this. I bought a house with a fixed-rate mortgage five years ago. The value of that house has increased by about fifty thousand dollars. The rent has increased as well. The principal and interest payment has not increased, however. This is a fixed-rate mortgage. It cannot change. Let’s assume any tax increase and increase in insurance cost has been covered by the increase in rents. Pretty cool, huh? Even if I didn’t pay down the mortgage at all, my loan to value ratio would have improved because the value of the house increased while debt did not. Thus debt is being destroyed. The reality of course is that we did pay down the mortgage and the dollars we used were worth less every year of the last five.
What has inflation done for me lately?
The rental value of this house has increased for multiple reasons. One is the increase in demand for affordable rental housing in my city. This is largely due to an influx of people moving here. It is also a factor of wages not increasing at the same rate as house prices. This makes home ownership unattainable for many. As you may recall from those dreaded economics courses, when demand increases and supply doesn’t increase as fast, then prices rise.
The price of the house has risen as well due to many people trying to buy houses in these more “affordable” price ranges. The cost to build a similar house is much higher now due to inflation in prices of materials. The rents have risen due to demand and inflation.
What did inflation do to my money?
Inflation also devalued our dollars. It takes more of our dollars to buy any given thing than it did five years ago. My one dollar today buys 3/4 of a candy bar etc. To simplify this concept a bit more, money that has been in the bank for the last five years making almost zero interest, is actually worth less than it was when it was put there. In other words, your money lost value in the “safest” place it could be put. This is why I suggest we re-evaluate our understanding of risk. If my money is being eroded by inflation then I need to find a way to keep up with inflation – at a minimum.
So if I am paying this 500 dollars per month to P&I (Principal and Interest) and have been for the last five years, what has happened? I am actually paying the loan back with less valuable dollars than I started paying it back with. Now that 500 dollars feels more like 400 dollars. So I am paying it back with “cheaper” dollars. This is in an inflationary market. The value of the house also increased – partially due to demand and partially due to inflation. So now my value is higher which has increase my equity. My loan is smaller due to pay down. And I get to pay that balance down with less valuable dollars?!?! NO! Actually your tenant pays that down with less valuable dollars. Pretty crazy, huh?
Because you took the “risk” of taking money out of a bank and buying real estate, your money has grown. Your equity has more than kept up with inflation and your dollars aren’t losing value in a bank account. I will take that risk all day long. So that fifty thousand in equity growth is not what it would have been worth five years ago but it also isn’t a negative number as it would have been had the money stayed in the bank.
If you were to utilize the BRRRR method, you may have acquired this property for none of your own money so you will need to find another deal to put that bank money in to keep it from being “inflated away”! This leads to the idea of infinite return. I hope this is beginning to make some sense. I hope that you are beginning to see some of the attractive qualities of long-term real estate investing.
Our government benefits from some inflation and will legally manipulate money markets to try to maintain a safe level of inflation. Betting with the U.S. government’s interests may be a good strategy. That is for you to decide.
While flipping is sexy and cool, it has none of the tax advantages as buy-and-hold investing. It also doesn’t hedge against inflation. It is a good way to generate cash for investing. It takes a deeper look to see the exciting aspects of buy-and-hold and it doesn’t make for good TV shows. The economic side of buy-and-hold investing seems dry until you see the affect it has on your net worth. Then it looks way sexier than the HGTV shows, in my opinion. And don’t get me started on the tax implications of both strategies—which HGTV rarely addresses in their flipping shows.
We do flip some houses but buy-and-hold is our long-term wealth building strategy and it is working. I hope this has added a slightly different perspective on debt and the economics of leverage. Let me know what you think and, as always, keep the main thing the main thing!