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An Exchange of Opinions # 23- Investing Before Inflation – By Klarise Yahya, Commercial Loan Broker, DRE: 0095710 MLO: 249261

Posted on 27. Feb, 2012 by in all, Magazine Articles

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If you’ve missed some of the prior articles, basic “beginner” guidelines on successful investing are in my book “Stairway to Wealth” available at LuLu.com.

Last month we discussed Investing After Inflation.  The thinking was that high inflation will generate offsetting high interest rates and high interest rates will naturally reduce property values. The takeaways were (a) raise as much cash as possible right now while rates are low and values are high, (b) park the money somewhere safe until (c) the government responds by raising interest rates, and (d) when rates peak – thus forcing values down – to invest with both hands.
Although promising, this approach generates reasonable questions. For example, won’t the value of the target building have gone up with inflation? And can we really expect values to be significantly less when interest rates peak than they are right now, when interest rates are low?  Won’t value inflation offset all or part of the decline resulting from higher mortgage rates?
Maybe it’s time for a little thought experiment. Let’s put some numbers to it and see what happens. Assume we have three years of 10% inflation followed by higher interest rates. Ten percent interest in a time of 10% inflation means there is zero net cost to borrowing money and no gain (net of inflation) to be made by lending it, so, absent government intervention,  rates will have to be higher than inflation just to attract lenders. Say, 15%. That’s one-third over headline (all items) inflation, which is about where rates are right now.
Further, let’s assume that rents and expenses automatically adjust for inflation so what we’re doing is isolating the impact of higher interest rates on (inflated) values.

Hypothetically, right now we have 10 units renting @ $1,200 a month. That’s $144,000 annually. Deduct vacancy @ 5% and expenses @ 38% and we have a net operating income of $85,000. Adjust for a Debt Coverage Ratio (DCR) of 1.2 and we’ll have about $71,000 available for principal and interest payments. That will service a debt of about $1,100,000. Add a down payment (say, 35%) and our property value is 1,700,000 (rounded).
Jump ahead three years. NOI has increased 10% per year (compounded) and is now $113,000. At the same 1.2 DCR we have $94,000 available for debt service. But rates are now 15%, making our maximum loan $620,000. The market demands the same 35% down payment, so the value of this property – burdened by the higher interest rates – is reduced to $950,000 (rounded).
Conclusion: What’s worth $1,700,000 today we’ll probably expect to buy for 56 cents on today’s dollar under the higher interest rates, hypothetically three years hence?  We wouldn’t want to be the seller under these conditions, but being the buyer would sure be nice, wouldn’t it?
There will be costs, however.  For example, over and above the normal expenses of refinance, if we pull cash out we’ll obviously be paying interest on the money we pull out. That interest will almost assuredly be greater than the interest we’ll receive when we deposit the funds somewhere safe.
Thus far we can be pretty sure, if we do this program, that we’ll be facing a guaranteed annual loss from the difference between the “borrow” interest rates and the “deposit” rates. And it will be for an unknown period. If that’s not enough to frighten the wobbly, I don’t know what is.
And how long will we have to absorb the negative? If peak interest rates occur three years from now we’ll soon be fully invested in splendid properties at very favorable prices. We’ll be skipping out the door to get our hair done. But if it takes ten or fifteen years, well, any likely gain will be much reduced by the carrying costs. The reality will probably be somewhere between these examples.  But just to firm up the concept, let’s run some numbers.

If we can borrow at 5% and deposit at 2% (possibly doable at the time this is written), and ignoring tax consequences, it’s obvious we’ll be facing a potential 3% annual loss on our cash-out. How serious is that? Well, let’s see . . . you know that property we referred to above? The ten unit? Let’s say you’ve had it for years. Your present loan is down to about one-third the property value, say, $565,000. You refinance it for 65% LTV and pull out maybe $500,000 after expenses.  You pay 5% interest on the cash-out money and 2% when you invest it safely. That’s a minus 3% difference on $500,000, or a negative of $15,000 a year (again, excluding tax consequences).
Three years go by and you’ve got a net of about $450,000 (the original $500,000 minus three years of $15,000 losses).  What can you do with that? Well, if we put 35% down we can buy a $1,285,000 property. Returning to our hypothetical three-years-in-the-future property, we notice that the Cost per Unit is about $95,000. If we could buy a $1,285,000 property at that CPU, well, we’ll be adding 13 or 14 units to our portfolio.
Right now, we have 10 units. After the new purchase we’ll have 23 or 24 units. If you play your cards right you’ll have turned your original ten units into an estate, and all because you underwrote a 3% annual hit back when rates were at generational lows.

Ok, that’s one possibility. But let’s look at the other side, what happens if they don’t? What happens if rates just sit there at 5% or less for the next 100 years?  What if we turn into another Japan?  What then? Eventually you’ll get tired of seeing that $15,000 evaporate every year, with no end in sight.
So one day you wake up early and go into the kitchen for the first of your breakfast beers and find the refrigerator empty.  It’s time to go to the store. On the way you start thinking, “Yeah, maybe buy a couple o’ units or something.”
Rates are the same as they were back in the day. We’re Japan, remember? That probably means values are about the same, as well. So you’re at the 7-11 and notice, for the first time, that there’s a real estate office right next door, between the convenience store and the manicurist. You walk into the real estate office, taking the remainder of the six-pack in with you because maybe the guy’s on the phone.
“Can I help?” he says, “What are you looking for?”
Your ten units were worth about $170,000 a door when you last refinanced, and if nothing’s changed then your $500,000 should be the down payment on about 8 units. You say, “Well, I’m kinda looking for about six to ten units or so. You got anything?”
What? You expect him to say, “No”?

He says he’s got lots. Just give him a minute to glance at the MLS and he’ll drive you past some and you can put a deal together before lunch. Five minutes later you’re in the passenger seat as he’s entering the freeway, trying to hide the beer in his lap.
And that’s probably the most likely future if rates stay the same.  When you think about it, it’s this: If you pull money out now you’ll have the funds to buy in the future, when there are two possibilities: (1) Rates go up and values go down, so you’ll buy more units at lower Cost per Unit prices, or, (2) We’re Japan. Rates and values stay the same, so you’ll still buy more units . . .  just not as many.
This is as close to a no-brainer as I’ve seen in some time. Either way you come out ahead.

Klarise Yahya is a Commercial Loan Broker. If you are thinking of refinancing or purchasing five units or more anywhere in the U.S.A., Klarise Yahya can help. Find out how much you can borrow! For a complimentary mortgage analysis, please call her at (818) 500-9966.  To purchase her book, Stairway to Wealth, please visit www.lulu.com.