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Something to Think About #27 – Deflation: It’s not the Odds, it’s the Stakes – By Klarise Yahya, Commercial Loan Broker – BRE: 00957107, MLO: 249261

Posted on 01. Dec, 2014 by in all, Magazine Articles

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Executive Summary: The investor faces four major risk scenarios, but they are not equally likely. Inflation is the most universal and is commonly addressed with higher interest rates. The least likely but most serious risk is deflation. Deflation is defined as an inflation rate of less than zero and characterizes a failing economy. It is addressed with lowered interest rates.

The data suggests the Federal Reserve has been fighting a deflationary battle since 2008. Costs have been in the trillions. This may have significant consequences for the investment community. 

There are risks to any investment. Some, but not all, can be minimized by sound management decisions. An apartment can be purchased in an area with high population density, above average per capita income, and limited available land. A robust reserve account can be maintained. Conservative tenant acceptance filters can be in place. All these, and others, help an investment through the occasional difficult periods. The thing these decisions have in common is that management can only influence what happens inside the plot lines. There are other risks that happen outside the property lines. Those risks are not management sensitive.

William J. Bernstein has observed that the four principal external risks are (a) inflation (expanding money supply; asset values increase; higher interest rates), (b) deflation (contracting money supply; falling asset prices; lower interest rates), (c) confiscation (new limitations on use; asset seizure; losing a lawsuit for damages) and (d) devastation (war; riot; natural disaster). These external factors are not affected by the quality of management because their solutions lie beyond the property.

These four risks are not equally likely. Some forms of devastationare fairly predictable (riots over basketball games won; riots over basketball games lost; officer involved shootings, etc.), but we haven’t seen war within the continental United States since 1865. Natural disasters happen at intervals (hurricanes; drought; earthquake 😉 but can often be insured around.

Confiscation risk is increasing as asset seizures and laws based on social engineering become more common. The Michigan Congressman Tim Walberg recently addressed the abuse of civil forfeiture in the Washington Post. He wrote “Clearly, with the size of the federal Asset Forfeiture Fund exceeding $2 billion in 2013, civil forfeiture is big business for the government.”

Inflationoccurs when prices rise and purchasing power falls. An inflation rate of 2% (what cost $1 one year ago now costs $1.02) is functionally the same as a decline of 2% in purchasing power. It takes 102 pennies to buy the same amount of goods that 100 pennies bought twelve months ago. Pennies are worth less.

Inflation is a compounding number. The Bureau of Labor Statistics has records back to 1913. From 1913 to 1933, the twenty years immediately prior to President Roosevelt taking the United States off the gold standard, inflation averaged 1.36% annually. A banana that cost $1.00 in 1913 cost $1.31 twenty years later.

In the 81 years from 1933 to 2014 inflation rose 1,730%. What cost 100 pennies the day we left the gold standard now costs $1,830. This is an average annual inflation rate of 3.65%. Losing that much annually compounded purchasing power is devastating to the accumulation of real (net of inflation) wealth. At a 3.65% annual inflation, an investment has to almost triple (after taxes) over 30 years just to maintain parity in bananas.

Gratefully, many hard assets are inflation hedges. If an investor expects inflation, the classic protection is to borrow as much money as possible now and pay it off in ever-depreciating dollars over time. Apartment buildings are one of several possible hedges against erosion of purchasing power. For example, a well located building purchased with a hypothetical 33% down will pay itself off over 30 years or less. At the end of that period the owner’s equity will have tripled from equity build-up alone. In this example inflation is offset by equity build-up and real (inflation adjusted) wealth can be preserved.

But inflationary gains, whether of income property or stocks, remain taxable and that is a net loss to the seller. The seller is taxed on the phantom gains at great benefit to the government. That is one very good reason why we are unlikely to see the end of government sponsored inflation. Another reason is the interdigitation of velocity and unemployment.

It’s reasonable to think of velocity as the number of times a dollar changes hands over a year’s period. Each transfer is a taxable moment, and the velocity of money is twinned to the rate of inflation: the higher the inflation rate, the greater the velocity.  If goods and services are expected to cost more tomorrow, the common wisdom is to buy them today. Let somebody else have the problem of holding depreciating cash; we’ve got the fresh apples, the new car, and the apple green Kelly purse.  Each inflation-driven purchase supports the chain of production and at some point hiring improves and unemployment falls. So some people argue that inflation is beneficial because it (a) increases tax revenues and (b) creates more jobs.

Inflation is the most common of Mr. Bernstein’s principal external risks. The least common, but potentially most damaging, is deflation.

Deflation is when the general prices of goods and services fall and the rate of inflation drops below zero. This is normally associated with falling currency levels and an economic decline. Deflation is an economic event, not a market event. An example of a market decline is the collapse of computer memory prices after 1965 and yet the general economy benefited massively. The falling prices were limited to the market for computer memory and did not affect the economy as a whole: it was a market event. Deflation, on the other hand, refers to shrinkage of the economy as a whole.

Deflation is uncommon, but sometimes chronic. Forbes (Asia) recently published an article by James Gruber noting that in 1997 Japan raised its consumption tax (taxes remove currency from circulation) and that was enough to tip the country first into recession, followed by deflation. It’s been 17 years and The Economist writes that Japan has just now (barely) escaped from deflation.

Other than Japan, there have been only a few periods of deflation within the fiat money countries. Hong Kong and Ireland had brief experiences, and some current observers see Europe approaching deflation. A month or so ago Paul Johnson, the historian and author, wrote, “Germany is the only major state in the euro zone that is still expanding, though it’s doing so at only 1% a year.” These limited examples show how rare economic deflation actually is in a fiat economy.

There are many foul consequences of deflation, but for the moment let’s consider how it might affect mortgaged property values. We know that inflation permits a borrower make the principal and interest payments with ever cheaper dollars. A $5,000 monthly loan payment might require careful budgeting immediately following purchase. Three decades later, when the building’s value and rental income have tripled (or more) that same $5,000 becomes a mere bagatelle.

Just as the counter to inflation is high interest rates, the prescription for deflation is low rates. This was accomplished by the Federal Reserve with its QE programs (now ended), and the economy avoided collapse, but it was touch and go for a while. The purpose of quantitative easing was to avoid economic deflation through low interest rates. It was not to jump start the economy, although politics required it to be sold that way. And it worked. After six years and trillions of dollars the economy (a) has not dropped below zero inflation and (b) the economy has not jump started.

Current high stock and real estate prices are not evidence of a recovered economy. They are functions of low interest / capitalization rates. Large numbers of people are still out of work and some have dropped out of the labor force entirely. Huge numbers are on one (or more) of the various government entitlement programs, with stress to the system. The Social Security Disability Insurance program foresees its own insolvency.

The possibility of deflation is now being addressed by mainstream observers. One of the indicators pointing towards deflation is the PCE Index (Personal Consumption Expenditure) published by the Bureau of Economic Analysis of the Department of Commerce. While other indexes may incorporate estimates of economic activity, the PCE is unique because it measures only actual changes in market prices. This indicator has recently been showing an inflation rate of 0.80%.

An inflation rate of less than one percent is not sufficient to stimulate the economy.

A deflating economy means the velocity of the dollar declines. Fewer products are sold. Factories are mothballed.  People are laid off.

This is happening. Intel, Texas Instruments, and Hewlett-Packard have all announced personal reductions. Microsoft is planning the largest layoffs in its history. Over 48,000 job cuts have been announced so far this year just in the computer industry.

The retailer Target has announced layoffs. GameStop has closed stores. The retail industry is down almost 35,000 jobs year-over-year.

Counter-intuitively in the era of ObamaCare, even health care employment is down 21%.

Layoffs chill spending. If your brother-in-law is laid off, he won’t be able to buy at all and you may be very reluctant to buy. People may shop at discount stores rather than Whole Foods Market. Restricted spending is reflected in the PCE, which as we’ve seen only 80 basis points above deflation levels. That’s less than Germany, the single remaining candle in Europe.

Paul Krugman recognized three problems with deflation. First, the economy grows when people buy new stuff. What was bought yesterday was included in the economic numbers yesterday. Only new purchases count for today. When folks believe goods and services bought tomorrow will be cheaper than they are today, they just . . . wait. Daily and seasonal purchases decline. Even long-lived items languish. People become less willing to borrow because the home / car / vacation will cost less if they just wait a while. So the family’s present car is squeezed for another two or three years of service. “Move-up” homes take longer to sell and transfer at a lower price. Forget vacations.

Secondly, deflation increases the burden of existing debts in real terms and the larger the payments, the greater the pain. Expect to see expanded garnishments, repossessions and foreclosures.

Finally, wages decline. A company in a downturn might mothball rather than sell its machinery. One day the machinery will again be needed, and buying new is much more troublesome and time consuming than opening the shuttered buildings and flipping a few switches. But people can be laid off today and replacements quickly hired as needed. Employees are friable.

All of Mr. Krugman’s points affect the apartment owner in a period of deflation.

People spend less: Tenants can be expected to migrate to lower cost units. If they are unwilling to move, they’ll attempt to bring in roommates to share the rent. Rent controlled units will find fewer vacancies. Animal spirits leave the economy. People will spend less even if their income remains stable. As noted above, items normally bought on credit languish.

Increases the burden of existing debts:  Mortgage payments, tax bills, utility charges can’t be expected to decline . . . but there’ll be fewer dollars to honor those and other obligations. The building purchased a year ago for $$$$$ is now worth only $$$. The owner is underwater.

Wages decline:  This is not the same as people spend less, which is on the demand side of the economic equation. Spending less is something people can change on a whim (“I really, really need those shoes!”). Declining wagesis a supply side issue (“But I don’t make that kind of money anymore!”).  Declining wages are serious. Forget new credit purchases. Cut wages mean that existing obligations can no longer be met. The apartment owner can expect more evictions for non-pay. Lowered wages and higher vacancies result in lesser net rental income which, in turn, means lowered apartment values. It’s possible that in a deflating economy current loans may not be re-financeable.

While inflation can be addressed by borrowing now to repay with cheaper dollars later (it takes 102 pennies to buy a banana . . . and not because the banana is bigger!), deflation is just the opposite. Bananas are offered at 98 pennies, or 96, or 89. It takes fewer pennies to buy something because the value of pennies has increased.

Current data seems to indicate a real possibility (not but not yet probability) of deflation, while at the same time the event horizon favors inflation. Might there be a way to (a) minimize losses should deflation happen and simultaneously (b) maximize gains under inflation?

Here’s a thought: consider the possibility of refinancing one or more existing apartment buildings. When inflation hits, you’ll (excuse me, your tenants) will be paying the loan back with inflated dollars. If deflation strikes, you’ll have the down payment already in the bank to buy another building or two at much reduced prices. Run this idea past your accountant.

This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional. 

Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email Info@KlariseYahya.com.

 

If you’ve missed some of the prior articles, basic guidelines on successful investing are in my book “Stairway to Wealth” available at Barnes & Noble (BN.com).