Inflation - Your Friend?

[yieldmatters]

I don't have to go work tomorrow so thought about this inflation thing more. Am sure I modelled this years ago but anyway, here's my spreadsheet effort.

I played around with it. There are a lot of different variables there which is good on one hand (flexible) but made it difficult to look only at inflation effects. I tried to keep other things the same - then increased inflation and interest rates to see what the effect was.

There is a technical issue with your spreadsheet I think. NPV needs to be on cashflow - not book gains. You seem to take capital gain every year as a cashflow for that year in your NPV. However you only get the cash at the end of the model (when you sell). Or alternatively you can get it year by year by using a LOC but then you would have to link your interest costs to the market value every year - not the original purchase price.

 

[WinstonWolfe]

I think this whole debate needs some assumptions to bring it closer to the real world -

off the cuff and with no reference to the stats:

• How is IR related to CPI ?

Strong association, IR has slight lag.
In the last 10 years or so, RBA policy makes it so.

• How is yield/rent related to CPI or IR ?

yield confuses things, because then rent becomes a dependent of growth. better to think whether rent correlates more closely to cpi or growth. I reckon it goes like this:

increased liquidity via lower IR -> growth -> inflation -> rent increases

• How is growth related to CPI ?

Growth is driven by higher liquidity (cheaper credit). Higher liquidity leads inflation, or inflation lags growth.

• How long is a time period should be measured ? Is 10 yrs to short ?

Anything longer than 1 complete cycle should see reversion to the mean of cpi, rates, growth, yields. Any part of the cycle is unlikely to last longer than 5-7 years, and a full cycle should be completed within 10-12years. I am particularly thinking of the flat property growth of the early mid 90s, then the compensating boom of late 90s early noughties.

To me, gaining insight into the effect of inflation (and accompanying ecnomic climate) has some practical value over time spans of 2-5 years.

• What is initial yield ?

Not important unless you want to revert things to the mean. The dumbed down question is how do specific economic climates with specific relationships between the variables (cpi, growth, rates, rents) compare? Holding the variables constant over 10 years helps to elucidate the comparative effect of each climate.

• How does rent/yield increase (with CPI or IRs or Growth) ?

yield lags growth.....because yields have to revert to the mean.....

• Is there a time lag between any of these variables ?

sure is.....some more than others....the shortest lag is between cpi and rates, thanks to RBA policy.


Spot on Keith....your questions are very much what needs to be considered....


Obviously is a theoretical world, low yields with high IR & low growth will make any investment a poor one in the short term.

And the long term.....

And this highlights why asking a question like "is inflation helpful to property investment or not", has little to no practical application.

One doesn't buy property in a bubble locked off from everything but inflation. Inflation is a dependent variable effected by supply/demand dynamics ergo the broader economic climate.

So a more erudite question is "how do various economic climates impact property investment?"

Q. What reflects the real world ?
A. Nothing really reflects the real world, because it's constantly changing. And there's no direct relationship between the variables.

I think there are strong associations, as elucidated above.

As others say, IR is pretty tight with cpi. The RBA make it so.....especially in the last 10 years.

I think most posters here are probably right for their chosen assumptions - some reflect the real world (my real world anyway ), some appear to be in their own world.

...........................

 

[Bill.L]

Hi all,

YM, I wont go on. WinstonWolfe's excellent spreadsheet does it nicely if you punch in the numbers.

First scenario purchase $100,000 LVR 100% growth 5% interest 10% cpi 5% rent constant yield 5%.

Second scenario purchase $100,000 LVR 100% growth 10% interest 15% cpi 10% rent constant yield 5%.

All you then have to do is look at the Annual equity +/- figure and the cumulative total at year 10.

Both are the same at the end of year 1 being -$1200.
However by the end of year 10, the low inflation scenario has cumulative equity of $10,685. The high inflation scenario has cumulative equity of $69,936.

What is the inflation adjusted value of these numbers??

Low inflation wages start at $20,000 by the end of year 10 $32,577
High inflation wages start at $20,000 by the end of year 10 $51,874

The total equity gained a a % of wages equals

Low inflation 10,685/32,577 = 32.79% of a yearly wage.
High inflation 69,936/51,874 = 134.82% of a yearly wage.

Clearly and unambiguously the higher the rate of inflation in the theoretical world, the higher the gains for the borrower.

Thanks Winston, that is an excellent spreadsheet to show the benefit of inflation.

Just to show the absurd, with a scenario of 40% growth, 45% interest rates, and 40% CPI, while starting at 5% constant rental yield, the wages grow to $578,509 per year and the cumulative annual equity is $2,677,652.

Absurd inflation 2,677,652/578,509 = 462% of a yearly wage.

I totally agree with Keith that this theoretical stuff is nowhere near reality. But the proof of JUST inflation and nothing else being good for the property investor borrower is IRREFUTABLE.

bye

 

[yieldmatters]

I totally agree with Keith that this theoretical stuff is nowhere near reality. But the proof of JUST inflation and nothing else being good for the property investor borrower is IRREFUTABLE.

WinstonWolfe made a different conclusion from his own spreadsheet.

It's easily refutable. I'd like to debate you on the numbers but you are all over the place so it makes me tired - not sure its worth the effort.

What about the extra $32K in interest on one of your earlier versions??

 

[WinstonWolfe]

I played around with it. There are a lot of different variables there which is good on one hand (flexible) but made it difficult to look only at inflation effects.

agree that it is complicated....there's no password so you can manually change the risk adjusted rate of NPV to be the same across the three scenarios.

However, this introduces error, because the risk adjusted rate moves with interest rates. In changing the RAR, I am attempting to make NPV reflect real returns, not nominal. i.e. accounting for inflation's varying effect on the value of a dollar in each of the three scenarios.

To fairly compare scenarios across several years, time and inflation must be equalized.

This can be done via NPV as I have attempted to use it, or IRR. But IRR doesn't work for many scenarios in excel because of its limitations in relation to negative positive cash flows.


I tried to keep other things the same - then increased inflation and interest rates to see what the effect was.

Well the way I set the ssheet was to emulate reality as closely as possible. Remember, inflation does not move on its own. I don't think there's much to learn from adjusting cpi on its own........unless you do it to find the strength of its gain compared to rates, growth, rents.

It is possible to do this.....there's statistics that calculate the relative % contribution variables have on a dependent variable.....but I forget how to do it.


There is a technical issue with your spreadsheet I think. NPV needs to be on cashflow - not book gains.

Disagree......I am doing fixed time comparison across three scenarios. I need to combine equity from growth and cash flow, then compare. Each scenario will have a different portion of growth and cash flow, and eventually, it is all equity you are comparing anyway....no advantage in keeping them separate, but lots of disadvantages.

The other way to adjust your thinking is to think of the comparison as having liquidated the property and taken the payout in that year. (though with no tax or out costs).

I also think leaving tax calcs out don't upset things. The comparison is over shorter time periods when the rate of tax on CF and CG will be similar.


You seem to take capital gain every year as a cashflow for that year in your NPV. However you only get the cash at the end of the model (when you sell). Or alternatively you can get it year by year by using a LOC but then you would have to link your interest costs to the market value every year - not the original purchase price.

.....see above.....it is all about comparing equity at fixed points in time (End Of Each Year)...equity in the sense of how much wealthier has this investment made me at this point in time.....

Further, I included rent adjusted via cpi in the purple text to show how doing so drops yield (rent / current property value) significantly across time. In real life, yields have to revert to the mean. They certainly don't follow growth. This is the problem with averaging out factors that lead and lag each other.

In reality, you wouldn't keep the variables constant across 10 years. I only did it over that time to accentuate the trend.

At most, I think an economic climate probably stays stable for no more than 3-5 years.

When talking about things reverting to the mean, it is important to remember that the mean is a mean of many years.....and mean figures do not realistically lend themselves to modelling many years.

 

[WinstonWolfe]

WinstonWolfe made a different conclusion from his own spreadsheet.

It's easily refutable. I'd like to debate you on the numbers but you are all over the place so it makes me tired - not sure its worth the effort.

What about the extra $32K in interest on one of your earlier versions??

Actually Bill, I haven't modelled CPI's effect independent of everything else.

The two scenarios with High CPI are the strongest and weakest outcomes.

Why? because one is accompanied by high growth and the other low growth. Which is why I reached the conclusions at the bottom of the spreadsheet.

YM, I haven't messed with holding everything constant except inflation.....I made a choice to emulate reality as close as possible.....but the ssheet should allow such a comparison. might do it later today if no one else has..


edit: ah sorry Bill....realize you have just done that...i.e. held everything constant except cpi.....

 

[Bill.L]

Hi YM,

Winston's spreadsheet takes that into consideration.

I've used the SAME theoretical numbers in both cases.

The cumulative annual equity in the spreadsheet adds the value of growth in the house price plus the rent minus the interest cost. At the end of year 1 both are the same, but from then on the compounding effect of the growth in both rent and equity kicks in.

It clearly shows that you are better off with inflation.

If you don't see it, you are choosing not to see it. They were your numbers, your scenarios, but put into an easy to see example, not the convoluted one you originally presented.

bye

 

[WinstonWolfe]

Actually, the other interesting scenario is to take rates right out of the equation, as if the property is fully paid off.

I am getting blinkered into thinking everyone is 100% LVR'ed....when in fact PI'ers would range from 0-100% LVR....

 

[yieldmatters]

There is a technical issue with your spreadsheet I think. NPV needs to be on cashflow - not book gains. You seem to take capital gain every year as a cashflow for that year in your NPV. However you only get the cash at the end of the model (when you sell). Or alternatively you can get it year by year by using a LOC but then you would have to link your interest costs to the market value every year - not the original purchase price.

This is not a minor technical error. It makes an enormous difference.

 

[WinstonWolfe]

This is not a minor technical error. It makes an enormous difference.

As I indicated above, a proper comparison of investments eliminates the effect of time and inflation on money, under the same and different economic environments.

If you take issue with cg being included in NPV calcs, then simply consider that in all three scenarios, the properties were sold privately and equity realized.

The equity +/- figure under each year is that year's contribution to equity (via cf and cg)....therefore, each year's NPV reflects the realization of the cg (as if it had been sold that year).

You'll have to be very specific in your explanation of why you have an issue with NPV being the fairest comparison in this manner.


BTW, I just recognised a few bugs in the spreadsheet. NPV wasn't updating when interest rates were changed in all scenarios.

HAve also moved comparison figures to top of sheet for easier use when adjusting variables.

 

[WinstonWolfe]

OK, my final word on all this......
I just modelled keeping everything constant except cpi.

growth and interest 7%
rent 5%
cpi 2,5,8%

I did it for LVRs of 100% and 0%.

The result is that low cpi is superior in each.

But the differences are reasonably minor...... less than 2% of property value at 10 years, and insignificant at 3 years.



If you want to do it, make sure you downloaded the spreadsheet after 1030am today, cos I fixed a couple of bugs.

 

[Bill.L]

Hi Winston,

What you are showing is some variations to what can happen.

What I showed was the effect of just inflation.

In my example growth = CPI = rental yield increases. Interest was +5%.

So in low inflation, growth 5% = CPI 5% = rental yield increases 5% (and started at 5%) interest 10%.

In high inflation, growth 10% = CPI 10% = rental yield increases 10% (and still started at 5%) interest 15%.

That is the only way to see the real effect of just inflation on 100% leverage.

With 0% leverage the effect of inflation is exactly the same in all inflationary scenarios, basically zero effect.

In your examples, of course you are better off with lower inflation if growth is a constant 7%, however what YM was trying to do was to take out the effect of any growth other than inflation.

bye

 

[s_t]

In your examples, of course you are better off with lower inflation if growth is a constant 7%, however what YM was trying to do was to take out the effect of any growth other than inflation.

bye

Exactly. That is what YM was trying to show - that it is more growth dependant than CPI dependant.

Why, cause YM doesn't think growth is going to continue, even if inflation does.

 

[WinstonWolfe]

H however what YM was trying to do was to take out the effect of any growth other than inflation.

bye

ah ok...can see the subtlety of what you are getting at.....will have another look at it later, from your perspective and YM's.

 

[yieldmatters]

If you take issue with cg being included in NPV calcs, then simply consider that in all three scenarios, the properties were sold privately and equity realized.

The equity +/- figure under each year is that year's contribution to equity (via cf and cg)....therefore, each year's NPV reflects the realization of the cg (as if it had been sold that year).

You'll have to be very specific in your explanation of why you have an issue with NPV being the fairest comparison in this manner.

I understand you have many NPVs finishing from year 1 to 10 (so you can take your pick on the term). This is OK - good approach infact. But you need to have the cumulative CG up until that year as single cashflow in that year. For example taking year 6 as 6 small CG cashflows doesn't reflect reality - if you keep it 6 years you can't access the cash from CG until year 6 so it would be a single cashflow in year 6 (sale price less debt outstanding).

This makes a difference when analysing the effects of inflation because cash from capital gain is cash delayed (can't get at it until you sell) which is eaten up by inflation (or to put it another way if the time value of money increases then the timing of cashflows is all the more important).

 

[WinstonWolfe]

I understand you have many NPVs finishing from year 1 to 10 (so you can take your pick on the term). This is OK - good approach infact. But you need to have the cumulative CG up until that year as single cashflow in that year.

ah ok....now I understand your POV....and have accounted for that in the past....will amend the spreadsheet so that cg's are delivered as a lump sum in the npv calcs by tomorrow night.......well spotted....though I did that ssheet in the middle of the night.


For example taking year 6 as 6 small CG cashflows doesn't reflect reality - if you keep it 6 years you can't access the cash from CG until year 6 so it would be a single cashflow in year 6 (sale price less debt outstanding).

This makes a difference when analysing the effects of inflation because cash from capital gain is cash delayed (can't get at it until you sell) which is eaten up by inflation (or to put it another way if the time value of money increases then the timing of cashflows is all the more important).

Yes, I get you now YM. And respect the energy, attentiveness, and passion you seek the truth with....

I also am only motivated to uncover the truth....I am not pushing a wheelbarrow....

I respect you and BillL for much of the passion you have expressed....and am highly motivated to uncover why two smart people can see things so differently.

I think the thing that makes somersoft so great is that you have reasonably smart people highly motivated to explore truisms.....

Above all, I respect inductive logic, the basis of the scientific method....but appreciate mankind wouldn't be where they are today without having relied on deductive logic......a paradox yes?

 

[yieldmatters]

Yes, I get you now YM. And respect the energy, attentiveness, and passion you seek the truth with....

I also am only motivated to uncover the truth....I am not pushing a wheelbarrow....

I respect you and BillL for much of the passion you have expressed....and am highly motivated to uncover why two smart people can see things so differently.

I think the thing that makes somersoft so great is that you have reasonably smart people highly motivated to explore truisms.....

Above all, I respect inductive logic, the basis of the scientific method....but appreciate mankind wouldn't be where they are today without having relied on deductive logic......a paradox yes?

If nobody looks at it again maybe there is no need to update it!! The thread had a blast of energy and then went dead.

Anyway - nice final post - pure poetry and all in bold ...

 

[WinstonWolfe]

yeah I'll have to stop shouting....
am just changing the cells now....but am doing some other stuff to make it more user friendly.
trying to polish excel skills is a certifiable illness...as is creating ssheets at 3 in the morning...

 

[s_t]

Without sitting down with someone and discussing the data/issues with them it is real hard to understand their POV and get yours across. It's a pretty complex issue to try and discuss/resolve with a few short posts!

.......................
I respect you and BillL for much of the passion you have expressed....and am highly motivated to uncover why two smart people can see things so differently.
.............

 

[WinstonWolfe]

Without sitting down with someone and discussing the data/issues with them it is real hard to understand their POV and get yours across. It's a pretty complex issue to try and discuss/resolve with a few short posts!

true, but the difficulty of communicating these concepts is forcing me to think more carefully about explaining and understanding them.....which is one of the nice things about this forum...it motivates one to go where no man has been before