Inflation: The Deciding Factor

inflationLast week you saw how pivotal (no pun intended) leverage is to the success of your investment in your home. Today we look at the second major factor: inflation.

Everyone loves inflation, no matter what they say.

The main reason? Inflation makes you feel richer. It usually increases your income, but most importantly, it pushes up the value of your home, and that brings us to the number 2 reason buying a home generally works as an investment.

Let’s be clear about one thing: inflation is pretty much the only reason the value of your home goes up.

This series, remember, is founded on the comparison between investing in the stock market (through an index fund or directly) and renting vs. buying a home. As the previous post pointed out in graphic form, an unleveraged home purchase is likely to return less for you than an unleveraged investment into the stock market.

There is an important reason why that will always be true.

Your Investments And Inflation

Corporate stocks derive their value from the profits those corporations earn. In the vast majority of public companies, profits grow from year to year as the companies sell more product to more people for more money. This has nothing to do with inflation — it’s due to more customers buying more products or services — FedEx shipping more packages, Sprouts opening more stores, Chipotle selling more burritos… you get the picture. You don’t have to do anything to add value to the investment — the management of those companies does that for you.

Your home has no intrinsic growth as an investment. Of course, if you improve the home by adding air conditioning, its value will go up but that’s you adding value, it’s not the home adding value by itself.

The only way the value of your home goes up is inflation.

Stocks increase value from inflation, as well. When ADM (the huge food company which feeds you every day without your knowing it) increases the price of their chicken breasts, their earnings go up without a single additional breast being sold. That gets added on top of the increase in value due to more people eating more chicken.

Inflation, therefore, adds to both home values and corporate earnings. However, inflation is pretty much the only source of gains in a home’s value, while corporate values benefit from both inflation and an expansion in customers, products and services.

That is why, over the long term, your return from the stock market is likely to outpace the return from a home as investment. Because most index funds are based on the stock market, that, by extension, applies to said index funds.

However…

The reason why an investment in your home eventually turns out better than an investment in stocks or bonds, is that thing called leverage. To understand why this works, consider the real underlying transaction: you are buying a home, and then renting it out to yourself. (In fact, that’s how the government looks at things for the purposes of calculating inflation and other statistics, but that’s another story.)

The reason that investment in you as a tenant works, is you can count on 100% occupancy. That makes the investment a safe one (assuming for the moment you don’t lose your job, but that’s also another story, which we touched on last week and will return to later). Because it’s a safe investment, you get away with greater leverage than you can with other investments. And that, the leverage, is what turbocharges the otherwise mediocre return on your investment.

And inflation adds a double boost by increasing the value of that investment.

Why We Can Count On Inflation

Inflation is inevitable, at least in our lifetimes, and here’s why: our government does everything in its power to keep it going.

Mankind does its best to learn from past mistakes. After the dust bowl disaster of the previous century, the U.S. made changes in agricultural policies. Learning from mistakes which were made, they implemented measures… and a dust bowl hasn’t occurred since. Same with the Great Depression of approximately the same era.

The biggest scourge of the Depression was deflation — the value of people’s possessions evaporating before their eyes. Since then, central banks around the world have always tried to learn from that mistake and to manage the world’s economy with a small amount of inflation “built in.” With the notable exception of the 1970s, when inflation got out of hand due to a unique confluence of events, they have been pretty successful.

Many people have criticized the U.S. Federal Reserve and government for their handling of the great Wall Street crash of 2008, but they lose sight of the Fed’s main objective: prevent the deflation of the Great Depression. They succeeded in that goal, and they have managed to keep a moderate amount of inflation since 2008. The target they would love to see is around 2% per year. Of course, it’s like a video game: you might aim for it, but you always overshoot or undershoot. There are too many people with too many disparate lives to create a uniform inflation number.

Regardless, you can pretty much count on at least a modest level of inflation for your lifetime.

And that is what makes a home purchased with a reasonable amount of mortgage debt such an attractive investment for an ordinary person… especially when you do the following comparison:

Reason #2 Why Inflation Makes Buying A Home Smart

This is pretty simple and we don’t need to say a lot about it: When you rent a home (pretty much any home) your rent will go up. Landlords do it to keep up with (you guessed it) inflation. Some landlords take it easy on the rent increases when they have good tenants, but even they raise that rent every so often. Over a 30 year span, your rent is pretty much guaranteed to at least double.

But when you pay down a fixed interest mortgage, your payments never go up — all that goes up is the value of your home.

Boom — double whammy for home buying: rent expense goes up for renters, but not owners. And the same inflation which pushes up renters’ expenses pushes up the value of your home.

So, when you look at renting vs. buying, you always need to look at the long term. Leverage (with a fixed rate mortgage) gives you that double whammy of home buying: no increase in “rent,” and long term appreciation on the full value of the home with only the down payment as the initial investment.

There is one catch to this, however, and it is an important one. Those who have followed my writing here and at other places know I often refer to my neighbor Jim. This “however” comes from him. But you’ll have to wait two weeks to get that, because next week we’re going to talk about something you hear a lot about, but mostly in error: income taxes. Let me just say this now: it will not be what you expect to hear. So stay tuned…

One Response to Inflation: The Deciding Factor

  1. Bob March 27, 2016 at 10:49 am #

    Thanks for this info. Heard California is pushing the minimum wage incrementally to $15. Expect this to help drive inflation, so based on this, we are going to start looking at homes. Happy Easter!

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