How does Inflation help in real estate?

Have you ever wondered what does it mean when your realtor, your friends and your well-wishers state that real estate investments act as a hedge towards inflation? How about if we are able to quantify the hedge (aka savings due to inflation). Let me help explaining what this inflation hedging mean in simple terms with examples.

What is Inflation?

Before understanding these details, let me take a moment to explain few technical terms related to Inflation.

• Inflation: General increase in prices over time and fall in the purchasing value of money.

• Inflation Rate: Rate at which the prices increase every year.

Example of Inflation:

To explain these 2 terms in layman words, here is an example. For example, today we can get 1 dozen pasteurized organic eggs for $10. Lets assume that on an average, the price of the goods aka inflation rate increased by around 2.6% annually. In 30 years from now, the same eggs would cost ~ $21.60.

If you only want to spend $10 even after 30 years, then instead of a dozen eggs, you might only be able to buy half a dozen at best.

This is how inflation affects the purchasing value of any goods that we buy over time. The same $ value today would loose its value over time…. This is what we call inflation and the rate at which we loose the value every year is called inflation rate.

Now, there are only 2 options where we can maintain the same purchasing price –

1. In a world without Inflation (Non existent)

2. Buy the goods today that can be used for the rest of the time(Hedging).

In our example, if only there is a way to freeze all the eggs, we buy all the eggs needed TODAY and never need to worry about the price of the eggs again in our lifetime.

What is real estate investment?

Now that you are clear on inflation, inflation rate and how it impacts the purchasing power over time lets move on to understand some basic terms in real estate.

• Sale Price : The price you pay for the home

• Downpayment: The amount you pay from your savings. Usually it is advicable to pay atleast 20% of the sale price.

• Loan Amount : The amount that you borro from a financial institution such as banks and credit unions. This is sometimes also referred to leverage.

• Interest Rate: Cost of borrowing the money.

• Loan Term: Total number of years by when the money should be paid back with interest.

• Monthly payment (EMI) : This is the monthly payment made to the bank. This includes interest (cost of borrowing) and principle (amount borrowed).

Example of real estate investment:

Lets take an example where we have a buyer who purchased a home with a 20% downpayment and a 30 year loan (a very common scenario)

Sale price………... $1,210,000

Loan Amount…. $968,000 (@80% of the sale price)

Interest Rate….. 3.5% (Hope we will get back to this day)

Loan Term………... 30 Years paid monthly (Most common term)

The most important point to note with real estate loan is that once the loan terms are finalized, all the $ amounts are fixed — loan amount, monthly payment, interest rate of the loan.

In this scenario, over 30 years period, the buyer would have paid the following $ amounts.

	Actual Paid
Interest	$596,830.93
Principle	$967,987.36
Total Monthly Payments	$1,564,818.29

Technically by borrowing $968K USD at 3.5% with a repayment period of 30 years, cost of borrowing is around $596K. (Hum that’s lot). And as you can notice, principle is nothing but the loan amount that would be repaid in small increments over 30 years. Now, you might be wondering that it is a lot of money that you are paying. Hold off on your thought until you understand the next section.

Lets bring back inflation into picture. Again, assuming that there is an inflation of around 2.6% annually. The same interest and principle amount in today’s value would be –

	Inflation adj Amount
Interest	$465,682.22
Principle	$639,652.14
Total Monthly Payments	$1,105,334.36

Do you see the difference in the interest paid and Principle paid when the 30 year amounts paid over time are all bought back to today’s dollar value. Let me put both these numbers together again –

	Actual Paid	Inflation adj Amount	Inflation Hedge
Interest	$596,830.93	$465,682.22	$131,148.71
Principle	$967,987.36	$639,652.14	$328,335.22
Total Monthly Payments	$1,564,818.29	$1,105,334.36	$459,483.93

Real cost of borrowing money after adjusting to inflation is around $465K instead of $596K there by saving approximately $131K. Instead of paying the loan amount of $930K, we are technically paying the loan amount of $640K in today’s currency value over 30 years.

Combining these 2 savings together, “Inflation Hedge” aka saving from Inflation rate adjustment in interest paid and loan repaid is nearly $459K.

To summarize, the cost of purchasing a house with a 20% downpayment at 3.5% interest over 30 years would technically cost us $1.35M instead of $1.8M.

	Actual Paid	Inflation adj Amount
Downpayment	$242,000.00	$242,000.00
Loan Amount aka principle	$967,987.36	$639,652.14
Interest	$596,830.93	$465,682.22
Total	$1,806,818.29	$1,347,334.36

Because all these savings called out are not reflected in your bank statements, it is really hard to understand the concept, quantify the savings and feel the sense of achievement until you start feeling the pain of paying either in purchasing or renting a house in future.

Action : Now that you understood the concept of inflation, pat on your back if you already own a home(s)….. if not, it is never late to buy a house (affordable) today. Good luck finding a house of your choice.

PS : This is almost similar to the scenario where I called out in the beginning, that if there is a chance, buy everything and anything NOW (real estate, gold, stocks etc.) that you can use for the rest of the life.