Tuesday, June 16, 2009

Inflation is a Monetary Phenomenom

Lots will be spoken about inflation in the months ahead. Most of it will be wrong.

Inflation is a monetary phenomenom. It is caused by poor money supply management by the Federal Reserve and nothing more. Yes, short term demand and supply issues can cause prices to rise or fall, such as a shortage of oil will cause gas prices to rise. BUT THAT IS NOT INFLATION. All market equilibrium forces that cause prices to rise are not inflationary. These are simply normal adjustments to the supply of goods and the demand for them.

Inflation is a systematic, long-term, and across the board increase in prices due to the fact that currency has less value. Think of inflation like the tide of the ocean. When it rises ALL prices rise regardless of the demand for an item or its supply because the medium of exchange, the currency, has less value per unit. Inflation acts like a cancer on the currency, eating away at its value much like rust chews on a piece of iron until there is little left.

Real estate investors often speak of inflation in glowing terms for two reasons.

First, they get to borrow using today's dollars and get to pay them back in tomorrow's inflated and lesser valued ones. True---but the corresponding balance sheet entry is that the value of the asset supporting the mortgage also is worth less in inflation adjusted terms. Coupled with implications of financial leverage means that this transaction is a money losing equation for the mortgagor. You get to pay back one inflation adjusted dollar to buy an asset denominated in many more.

Second, inflation disguises the actual yield investors earn on real estate buys. We have all heard stories of people bragging, for example, that they bought a home for $100,000 in 1978 and sold it for $600,000 in 2009.

Great deal, right? NO.

$100,000 in 1978 is the same as $326,543 in today's dollars. (See the effect of inflation?) Turning $326,000 into $600,000 over 29 years is a 2% rate of return. And this does not include property tax payments, maintenance, sales fees, assessements, and more.

Inflation is the great hidden tax, the largest destroyer of wealth possible because it affects everyone, rich and poor, savers, spenders, and investors.

I urge you to understand the monetary roots of inflation and don't get distracted by all the talk of this price rising or that price falling. Inflation is, at its core, a reflection on the currency or, in our case, how many dollars are chasing the same number of goods and services for sale.

The impact exploding inflation will have on real estate investors in the next few years will be crippling on your capital gains, operating expenses, and borrowing costs.

Robert J. Abalos, Esq.