What has the government done with our money?
In 1971, President Richard Nixon took America off the Gold Standard—a monetary system where the value of a country’s paper money is directly linked to gold. This transformed the U.S dollar into a fiat currency—our currency was no longer backed by anything with intrinsic value (gold) and an endless supply of money could now be ‘printed’. This measure in 1971, opened the door to a sea of money printing and the devaluation of the American dollar.
Fast-forward to 2020 there is a financial crisis which is triggered by a health crisis (Coronavirus) and the American Economy is in need of stimulation to prevent a large scale bankruptcies in both the private and public sector.
Normally during economic crises the Fed would lower the Fed Funds Rate to stimulate the economy. However, since interest rates were already near 0% before the crisis a further decreases in interest rates is going to have little impact on the economy.
The Federal Reserve must turn to Quantitative Easing—purchasing securities (debt assets) owned by banks and other financial institutions to provide them with liquidity (cash). Historically the Fed only purchased high-quality securities (government bonds); increasingly this isn’t the case as the federal reserve continues to move down the risk spectrum and purchase riskier assets.
Where does this money come from and where does it go?
The Federal Reserve acquires the money used to purchase these securities by ‘printing money’. More accurately, it creates electronic bank deposits which are held at the Fed. This money is then transferred to banks providing them with the liquidity they need to service their debts and purchase other riskier financial assets (i.e., stocks, corporate bonds, mortgage backed securities, etc.). Thus stimulating the flow of money through the economy and triggering the economic recovery.
The main takeaway is that with interest rates near zero in order for the government to stimulate the American economy the Federal Reserve must utilize quantitative easing. However, the Federal Reserve doesn’t have the money needed to purchases these securities, but what it does have is the ability to create money. This means that the only way the Fed can stimulate our economy is by printing money and increasing the monetary base (M0).
When congress approved the CARES act— a $1.8 trillion dollar response to the Coronavirus. The Federal Reserve increased our monetary base from $4 trillion to $6.7 trillion with further stimulus in the works. I would be shocked if we don’t see high inflation in the coming years. Although it isn’t a given because many thought that there would be large scale inflation due to the quantitative easing that occurred in 2008, however there was only moderate inflation from 2008-2020.
What is Inflation?
Inflation is the general increase in prices and the loss of purchasing power from the dollar.
There are causes of price inflation:
- An increase in demand/reduction in supply for a good or service
- An increase in the cost needed to create that product or service
- An increase in the money supply
Today we are going to focus on the third cause of inflation an increase in the money supply.
How can real estate investors benefit from the coming inflation?
Real estate investors can take advantage of inflation by acquiring long-term fixed-rate debt. If the U.S dollar does devalue 20% over the next ten years, when you pay the lender back you will be paying them back with devalued dollars. The numerical amount is constant but the value of those dollars has decreased because there are far more dollars in circulation. As an investor you are essentially receiving a 20% discount on the loan amount.
Another way that real estate investors can benefit from inflation is that multifamily leases are relatively short-term. As general prices rise multifamily investors can increase rent at the same to offset the effects of inflation. Therefore increasing the value of their property and acting as a hedge against inflation.
What affect will this have on inflation and how can you as a real estate investor profit from the actions that the federal reserve is taking?
In as simple of terms as possible there is an influx of money being thrown into the economy. But money and wealth are separate things. Money is the dollars in your bank account used to buy goods and services. The goods and services in the economy are the equivalent of wealth. The government isn’t creating more wealth—no more goods and services are available for consumption because of quantitative easing. The government is only creating money and a lot of it. If there is a run on goods and services which is the equivalent of a bank run then we are likely to see hyper-inflation.
The remaining question is how can we as real estate investors profit from this coming inflation?
By acquiring long-term debt with fixed interest rates investors can profit from the coming inflation. If acquire a property with long-term fixed-rate If there is inflation from the Fed’s economic stimulus, let say that it is 20% for illustrative purposes. Then the money that you are paying the lender back in is devalued—meaning that it has lost 20% of its purchasing power, effectively translating to a 20% reduction in the debt placed on the property. Meanwhile, the one-year leases for multifamily provide you with the flexibility to increase your rental revenue as inflation rises.
Now remember that there is a difference between good debt and bad debt. Good debt grows your income stream and will eventually pay for itself e.g., rental properties, college education, business loan. Bad debt is money that you spend to increase your lifestyle, e.g. new car, vacation home, etc.. By acquiring good debt and waiting for inflation to occur you are not only protecting yourself by acquiring an asset that will rise in value but the debt is fixed and when you pay that debt off you are paying the lender with devalued dollars.