Why Inflation Will Crush Real Estate

Economist Marc Faber said on April 6 on Financialsense.com that U.S. real estate is a good asset to invest in. I strongly disagree. He worries too much about the risk of hyperinflation and this motivates him to seek out any type of tangible asset in hopes it will protect investors from inflation. However real estate in the U.S. is not the same as gold bullion because real estate is usually purchased with a mortgage that is underwritten by bank creditworthiness standards. When people buy gold they pay for it with savings instead of using borrowed money. If consumers have a drop in income or if interest rates go up then they will have less borrowing power which means less purchasing power and then the price would go down. During a period of high inflation people actually become poorer in real terms so they will be forced to buy a smaller home. If inflation were to return as it did in the 1970’s lenders would insist in being compensated by charging higher interest rates. When interest rates hit 22%, as they did in 1981, then almost no real estate will be purchased with the exception of a money-losing “owner carried back” mortgage Note that is at artificially low rate of interest.

Today’s mortgage market operates under strict underwriting rules where the self-employed borrower must use a two year average of income. Since small businesses encounter a lot of economic volatility then the owners of those businesses may not qualify for a loan because their 24 month average is not adequate even though they are currently earning enough income. Since many buyers are two income couples then if one family member is self-employed with shaky income then the entire family could not qualify even though they currently earn enough. From 1984 to 2009 the banks used “Easy Qualifier” loans that allowed people to lie about income. This caused people to get too much borrowing power and made real estate prices go too high. Today we are in a new era that does not compare with the 194-2009 era because lending standards have changed. In addition there are a lot more independent contractors today than in the pre-1984 era, so we can’t compare personal income of the pre-1984 era to today’s earned income. In the pre-1984 era people had a simple salaried job, while today they may have a mixture of salary and bonus or self-employment. (Bonus income requires a two year average for loan approval, so many people can’t use it to qualify for a loan).

Massive money printing hurt real estate

On a qualitative basis personal incomes in the U.S. have not improved as much as the numbers suggest because the unreliable nature of today’s independent contractor, self-employed, or salaried with large bonuses type of income can’t be fully relied upon to service a mortgage. The return to traditional loan underwriting recognizes that and is thus offering less mortgage credit than one would expect by simply looking at the nation’s per capita personal income. Ivy Tower economists fail to recognize this and conclude that the ratio of per capita income to today’s low mortgages rates somehow makes homes affordable, but that is incorrect. In investment analysis one must make adjustments for excessive risk. For example one could discount a cash flow using a more severe discount rate for an investment that is very risky, for example a company located in an unreliable Emerging markets country. For U.S. consumers using earned income to borrow funds and buy real estate, a lender must “discount” the borrower’s income by adjusting for the increased riskiness of personal income. Another mistake economists make is to not see that outside of urban high wage areas that personal income has not kept up with income earned by the urban elites, so that means homes for the bottom 90% of consumers have a potential pool of buyers who did not get the same share of income that they had received in previous decades. This explains why Palo Alto and Manhattan are bullish markets while the rest of the country prices are still declining.

The best hedge against inflation in the 1970’s was ironically short term bonds and cash because the high interest rates paid then compensated for inflation while stocks performed badly. Real estate in the 1970’s benefited because borrowers used artificially low 30 year fixed rate loans that were not priced to reflect inflation. I don’t expect that to happen if inflation of the 1970’s returns.

I am not forecasting a return of inflation, simply commenting that real estate is not an inflation hedge.

About the author

Don Martin, CFP®

One Comment

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  • Don…. You are mixing different suits in the deck that were larglely independent when recounting the 1970’s. Interest rates, inflation, and household purchasing power were somewhat mutually exclusive to each other. House prices went bubbly upward in their inflationary roll to the glee of real estate owners.

    Increasing gasoline prices from the Arab oil cartel, too much government spending that decade, too much money in circulation fueled the inflation. Classic wage-price spiraling upwards had increasing demands by employees for more income, and they were getting it, continuing the inflation. Purchasing power was maintained, not lessened. There were exceptions. The Carter administration held military personnel, many who made sacrifices going to Vietnam in service to their country, stop getting increased salary at their paygrades as a demonstration of the government’s resolve to break the back of this inflation. It was the backbone of the military that got broken. The military tragically lost its work force of mid-career servicemen to civilian employers that paid more. A cheaper dollar meant more expensive imports. Otherwise, work was plentiful for wage earners, and they walked to the next employer if the current one was not accomodating to cost of living increases.

    Mortgage interest rates remained in the 8 to 9% range because someone was asleep at the the Federal Reserve, and President Carter’s administration who could have put pressure on the Reserve for higher rates failed to do so. But the party was on and the punchbowl was in place. People who owned real estate–their homes and investments– saw their valuations soar. Smart people used low down payment purchases for their new homes and rental income real estate to see handsome annual rates of returns while paying the debt on increasingly cheaper, inflated dollars. Rents went up, but so did demands by renters on their employers. Acquiesence by employers fueled the inflationary spiral upward. The economy was robust and people had jobs with rising salaries and wages, and competitive exports made employment good.

    Contrary to your last statement, real estate was a handsome hedge as net worth climbed by owning real estate especially when levered with high debt. After Paul Volker put the stake into the heart of inflation which affected mortgage rates by climbing sky high rather than property valuations, the economy was moribund for years as its appropriate medicine. Construction of new residentials stopped, but except for the last person to buy real estate, very few suffered with any dramatic house decreases. People still had jobs and real estate, all be it the mortgage debt didn’t get cheapened as quickly with dollars that earlier became less valuable via rampant inflation. Houses were still purchased, just not with new 18% mortgages. People across the country bought by by doing simple assumptions (as opposed to the later qualifying assumptions) of sellers’ mortgages; sellers’ equities were addressed by terms on promissory notes between seller and buyer. By the late 1980’s, newly originated mortgages had alienation clauses not readily allowing for assumptions, but by then new fixed rate mortgages were originated with a 9% handle, and adjustable rate mortgages (ARMs) were being used with lower start rates on the loan. These ARMS proved successful for borrowsers as market interest rates remained steady or continued downward.

    With the exception of buying via simple assumptions at the time…conventional, VA, and FHA which was the trend in doing, I can’t argue with being forced to buy a lower priced house when mortgage rates are higher as you described in your first paragraph. However, one is smart to acquire a fixed rate mortgage when buying a property and do it during inflationary times. The monthly payment goes toward paying the debt in cheaper, inflated dollars each month, as described above in the history of the 1970’s. What one loses in ability to purchase a higher priced property is consoled during years of inflation that may ensue. As everything goes up around you, that fixed payment will in effect be cheaper and cheaper. The price paid for the house will appear cheaper over the years as house prices rise during inflation. Yes, I agree, house prices don’t grow to the sky, for as you say, higher mortgage interest rates will slow or stop buying now that simple assumption mortgages became a dying breed. A home buyer does have to be prepared to sit out higher interest rates that slows the arrival of the next buyer of his house. If would-be seller has the ability to rent it instead while rates are up creating a slow sales market, more power to him. In the history of cycles and inflationary periods, however, rates go up and they come down.

    Finally, Don, when you refer to inflation making your fixed asset (like a house) appear to be higher in valuation during inflationary periods but is not so because the inflated dollar got devalued over that time with regards to purchasing power, that is true in the context of cost of living increases. However, if the fair market price I ask for my house I put up for sale is what comparable properties are selling for subsequent to a period of demand and inflation, and I appropriately receive my price from a buyer, I may show a substantial gain over my cost basis that include non inflation / demand driven appreciation and inflated dollars. I can take the gain to use as a down payment to leverage myself into my next, higher quality house I wish to purchase. I may qualify even if interest rates are higher should my wages/salery be adjusted for cost of living inflation. The “stepping up” process is as American as apple pie and has occurred over decades. When you refer in some essays to the dollar becoming less valuable relative to an international context, you are presumably saying our currency is worth less compared to that of other nations. That is true, but I only care about my domestic, inside my country’s real estate market, unaffected by the dollar against other international currency. Also, as you have stated, buyers with more empowered currency due to the US dollar weakness may bid up real estate prices.

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