Inflation - Your Friend?

Y

yieldmatters

All,

I often hear the claim in this forum that inflation helps a geared investor because the asset value will increase, the rent received will increase, but the loan will stay the same. Or to put it another way the real value of the loan will decline to a level that is very small over time so in that sense inflation is your friend.

I haven't sat down yet to do the mathematical proof but I don't believe it just on principle.

Why? Because inflation adds nothing to the real economy - it's just the same goods and services there with a higher price tag. So if nothing real has been added to the economy and the geared investor is benefiting from inflation then you have to ask who in the economy is losing from it? There has to be an equal loss somewhere else.

Happy to be proven wrong. Interested in your thoughts.
 
Yes, inflation is my friend because I used loans to invest.

Who loses? Whoever lent me the money. Now, the bank is just making a spread on the interest, so they're not really losing. So who is losing? The people who gave the BANK the money. In the end, it's depositors with money in those 'savings' accounts that pay zip interest, investors who buy bank bonds, etc.

But they don't KNOW they're losing, either because they don't understand inflation, or they don't care because that's not their objective. The person who has money in a 'savings' account paying 0.5% doesn't really understand how they're losing 5% or whatever a year and how over the long term this erodes the value of their cash. They just see the security of money in the bank, being able to see their balances on their statements, having their money 'backed' by a well known bank, etc.

On the other hand, a bond fund manager, say, doesn't look at real returns. I doubt most of them even look at 20 year returns: they'll looking at nominal returns and how much they beat Treasuries and how they did compared to other bond funds. The people who provide funding for the banks don't look at how inflation affects them over the long run. To be fair most investors don't understand it either, they just see its positive effects.

So it's actually the best kind of setup. I benefit from inflation. The people who lose to inflation don't realise they're losing. Will they realise it, eventually, and draw their money out? I doubt it. You're asking people to think long term, which rationally they should, but being people they won't. There'll be ups and downs (we're in for one of those downs), but over the long run, people still save money. And they have to have somewhere to put it.

This is not a mathematical proof at all. It's just how the real world is.

To sum up: inflation is my friend. It's not everyone's friend. And it's the enemy of the people who put money in transaction accounts and buy bank bonds. But they either don't know inflation is their enemy, or they don't care because that's not what they get paid on.
Alex
 
yieldmatters said:
I often hear the claim in this forum that inflation helps a geared investor because the asset value will increase, the rent received will increase, but the loan will stay the same. Or to put it another way the real value of the loan will decline to a level that is very small over time so in that sense inflation is your friend.

I haven't sat down yet to do the mathematical proof but I don't believe it just on principle.

Why? Because inflation adds nothing to the real economy - it's just the same goods and services there with a higher price tag. So if nothing real has been added to the economy and the geared investor is benefiting from inflation then you have to ask who in the economy is losing from it? There has to be an equal loss somewhere else.

Happy to be proven wrong. Interested in your thoughts.
Click to expand...
I think inflation was invented:rolleyes: to make the unwashed masses feel they are getting ahead. Their wages increasing is a tangible & feelgood thing, OTOH inflation is invisible. So everyone has the feeling of more $$ coming in, when in reality, just the same number of $$ are stealthily being expended.

So it's not really a case of people losing, but on average no-one getting ahead. Individuals getting above inflation pay rises are balanced out by cheap graduates coming in at the bottom and expensive retirees disappearing from the other end.

From a mathematical POV, provided the difference between the cost of funds and the investment yield is less than the inflation rate, then the geared investor is getting ahead financially.

From a risk POV who benefits - depositors benefit from lower risks & receiving low deposit rates, investors are paying higher IRs & taking higher risks & benefitting from higher long term rewards ? Look at the insurance industry, who benefits ? What they create is peace of mind - an intangible.

The financial losers are those that don't keep up (ie you & the other renters) with OOs. But they do benefit from more disposable income today. So I would say it's not an equal loss somewhere else, but a smaller gain (in inflated $) elsewhere. (Almost) everybody wins, just some win bigger than others.

Also have a look at investorsdirect.com.au(?) I believe they have an acticle promoting property as simply a means of procuring loans so as to benefit from inflation.
 
Inflation is my BESTEST friend. I adore inflation. We go WAY back :D

Inflation is not the friend of those on fixed incomes or fixed yields.

I am assuming Inflation has not gone wild. That's not much fun for anyone because then Italian shoes cost way too much :eek:
 
Still doesn't sound right so I tried a small model. I assumed:

  • Constand bank spread of 5%
  • $400,000 House - rises with inflation (for the sake of the exercise)
  • $350 / wk rent - rises with inflation
  • 80% ($320K) debt
  • 10 Year time frame (capital gain is realised and debt is cleared at this point)
  • Repayment of $36K / Year - rises with inflation (why not - if your wages are rising with inflation this would be easy)
  • Then I translated the whole thing to cans of coke to get some idea as to what happens.

I ran the model once at 2.5% inflation and I got 447,692 cans of coke IN, 336,823 cans of coke OUT for a net positive of 110,870 cans of coke.

I ran it again at 6% inflation and I got 447,692 cans of coke IN, 346,877 cans of coke OUT, for a net positive of 100,815 cans of coke.

Seems to have a negative wealth impact when inflation is higher. Any views? Have I got something wrong here.

http://www.4shared.com/file/43190957/ced67daf/inflation.html

Interestingly, on a side note the market yield is less than the interest rate all the way along and both scenarios still make money.
 
You've negated the whole benefit of inflation by increasing the repayment!!! Repayments don't increase with CPI!!!!!!!:rolleyes:
 
keithj said:
I'd expect yields to be higher in a high IR environment, not fixed at 4.5%ish. Would 75% of IR be reasonable ?
Click to expand...

Yes - sounds fair. I think that's the answer keith. Inflation can be your friend but it's not the diminishing real value of the loan that drives it - it is the much higher rent you can collect. So I think we have identified the loser in the relationship - it's the tenant.

If you held rental yield at 75% of IR and then inflation moved from 2.5% to 5% then their rent would jump 33% (This assumes the bank spread is a constant 5%).

Or to go back to the COKE index - their rent would jump from 17,000 cans of coke a year to 23,000 cans of coke per year!
 
Follow up thought now that the last puzzle is solved (thanks keith).

We established the loser in a high inflation environment is the tenant and the winner is the landlord.

This assumes though you can actually extract that sort of real rent increase out of a tenant (i.e. can they or will they give up the coke??!!). If not, who would the winner and loser be then?
 
yieldmatters said:
Thanks. I went back and made them flat ($36K / Year) and I got the same answer. Inflation means less coke.
Click to expand...

I only just looked at your spreadsheet.

You've coupled interest rates to inflation. You wouldn't expect much diffence then. Try fixing the rates.

I made interest rates fixed at 9%. The difference now is 75,069 vs 140,839. So what do I want as an investor? High inflation....and a low interest rate.......If you are an American, right now could be the opportunity of a lifetime!
 
s_t said:
I only just looked at your spreadsheet.

You've coupled interest rates to inflation. You wouldn't expect much diffence then. Try fixing the rates.

I made interest rates fixed at 9%. The difference now is 75,069 vs 140,839. So what do I want as an investor? High inflation....and a low interest rate.......If you are an American, right now could be the opportunity of a lifetime!
Click to expand...

Variable interest rates are related to inflation typically. But you are correct - if you score a fixed rate for 10 years and inflation goes up then you are on a ticket to riches! (and the loser is the lender!). Hard to outsmart a lender though - if you take a long fixed rate and they expect inflation to go up they normally build in enough fat to cover themselves.
 
yieldmatters said:
Follow up thought now that the last puzzle is solved (thanks keith).

We established the loser in a high inflation environment is the tenant and the winner is the landlord.

This assumes though you can actually extract that sort of real rent increase out of a tenant (i.e. can they or will they give up the coke??!!). If not, who would the winner and loser be then?
Click to expand...

Hi YM
It is interesting that you think that it a single winner single loser situation in a high inflation environment. I might suggest that winners are those that hold tangible assets (of which real estate is one, precious metals and commodities are others) and the losers would be those that don't have those assets such as tenants, fixed income retirees, people with high non deductible debt etc,etc.

Even if you owned your own PPOR, if your income is not linked to inflation then you would be a loser in a high inflation environment as your purchasing power would be eroded by inflation. Those who hold additional assets other than their PPOR, in those classes that do well in a high inflation environment will gain more than those who have limited assets (assuming that they can afford to hold them). The pain is spread throughout society but the gains would limited to few players with appropriate asset types.


Cheers

Shane
 
In real terms the value of the loan decreases.

All other numbers remain around the same in real terms. Wages, rent and house values rise with inflation. The loan remains the same so in real terms it has declined.

My parents borrowed $10K or thereabouts in 1971. How nice does that now sound for a house loan? Even if they had never paid a cent down over the past 3 - 4 decades and interest rates hit 20% they would only be paying $2K per year. I wish!

In an inflationary environment paying down the loan also becomes easier. $10K could be paid down by mosty people within a year.

Regardless of what your model does or doesn't say this is what happens in reality
 
Hi Shane, YM has focused this thread on the GEARED investor. ie. is gearing beneficial in times of high inflation?
 
GoAnna! said:
In real terms the value of the loan decreases.

All other numbers remain around the same in real terms. Wages, rent and house values rise with inflation. The loan remains the same so in real terms it has declined.

My parents borrowed $10K or thereabouts in 1971. How nice does that now sound for a house loan? Even if they had never paid a cent down over the past 3 - 4 decades and interest rates hit 20% they would only be paying $2K per year. I wish!

In an inflationary environment paying down the loan also becomes easier. $10K could be paid down by mosty people within a year.

Regardless of what your model does or doesn't say this is what happens in reality
Click to expand...

The value of the loan decreases in real terms - true - but you pay extra interest to compensate. So the bank is not the loser here - no free lunch from them unfortunately.
 
hi all
one area that you have not mentioned that rises the highest in an inflation market place.
comm
as cost increased fuelled by inflation the normal comm loan is pegged to a rate usually a 5% increase now if you have a inflation figure of say 8% then the comm (usually a 5 x 5 term) goes for 5 years and then it has to catch the market at the end of the first term and thats when you see big jumps in rents which is what you are seeing now.
the costs are pegged and as inflation takes the cost up so does returns.
at the moment you have returns over 12.5% and rising.
unlike resi when you have mass fall out in comm rising rate increases returns and if the cpi went to 10% it auto throw my leases up by 10%.
and heres the rub in the lease as soon as the cpi is over 5% the rent jumps by that cpi value that month the cpi is running at about 1.5% I would love the rates to take it to 6%(don't think it will).
my income increase if the market goes up or down.
if rates fall its cost me less
if the rates rise my leases go up.
and the comm market at this stage is the only one still lending relatively easily
and yes inflation is our friend and thats why I am buying.
and no there is no such thing as a free lunch but the bank is lending at say 8 or 9% but the return is 12% and a 5% annual in 5 years the bank has made its money but you have half of there money and you have increased your equity position buy 25%
as you have a 25% increase in lease return.
so yeildmatters please tell me side of the desk you would like to be on.
the bank or the investor.
I'll be on the investor side and if you can invest better then the banks your doing ok in my book
 
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