Knowledgeable investors should skip this post. Learning investors should live by it. I’ve posted some excruciatingly rudimentary basic information about investing on this site. While brutally simplistic, these are the things I wish someone had spelled out to me, when I started investing 35 years ago. This is another in that series. I consider understanding inflation to be the key to understanding investing. All of our lives, we have all been taught to measure value based on cash. Dollars. This is a conspiracy akin to teaching people the sun revolves around the earth. How many times have we heard, “My house has doubled in value over the last 10 years.”? Does it provide shelter for twice as many people? Is it twice as nice? “No. I painted the dining room and installed underground sprinklers. Now it’s worth twice as much.” Nobody’s home has doubled in value over the last 10 years. What has happened is, money has lost half it’s buying power, thus, requiring twice as much to buy the same asset. Cash is a depreciating asset. Inflation exists so companies can reduce labour overhead, over time. While inflation speeds along at 7% pretty reliably, we receive 1~2% raises (or perhaps 3% if we are a star) and are happy to get it. Over time, we are disadvantaged. This is why we have to change jobs every several years, to maintain our standard of living. Inflation makes it difficult to provide for retirement. 99% of people save for retirement and then spend those savings at the slowest rate possible the final 5~15 years of their lives. To retire for a longer period, you would either have to save a ton of money to overwhelm inflation or your gains would have to outstrip inflation. Think about this. If you save 50% of your net salary for 25 years, you should be able to retire for 25 years and live just as comfortably as when you were working. Suffice to say, not many people are able to accomplish that. Inflation reduces their retirement.
Those saving for their retirement by ultra-conservative means (GIC ladder, bonds, couch potato, mutual funds) will generally not keep up with inflation. These people would be better off to set aside enough money for a rainy day and then enjoy a nice lifestyle as long as they can, with their retirement savings taking place at the last possible moment. Those who can outpace inflation should save as much, as early, as possible. There is an investing rule of thumb which tells us that at 7% compounding annual return, an investment will double in value every decade. Inflation has generally averaged 7%, causing the buying power of money to halve every decade. If a loaf of bread costs $4 and you are earning 3.5% returns, that means that you can save $4 and in 20 years, you will have more than $4 but you won’t be able to buy a loaf of bread. You will have to save enough money for multiple loaves of bread in order to be able to buy one loaf in 20 years.
The cost of real estate doubles every decade, or so. That puts R-E appreciation at 7%, in my town. My parents bought a house in 1966 for $8200. That included a china cabinet ($125 upgrade) and R10 insulation (R7 was the standard, at the time) for an additional cost of $25. My dad was an HVAC contractor, so he installed the furnace for a saving of $300. Let’s round the purchase price up to $9000 to eliminate the sweat equity and to ease the math. Let’s follow the market value of the house, over time. 1966 -> $9000 1976 -> $18,000 # I have no idea. I was still in school 1986 -> $36,000 # Definitely. It was worth more than this but we came through high inflation in the 1970s. 1996 -> $72,000 # For sure. 2006 -> $144,000 # About right 2016 -> They sold it for $310,000 in 2016. Over the years, they built a garage, shed, and planted a lawn. They also replaced the livingroom carpet once and repainted the upstairs once. The house was extremely tired when it sold. I’ve done this work up on other homes, also. It generally works, with a few exceptional cases on the down side with extensive foundation damage and on the upside where the location has become the hot place to be. That houses appreciate at the rate of inflation is not surprising, as housing is the primary component in calculating inflation.
Owning real estate will keep up with inflation, while holding cash will lose to inflation. Let’s consider a very average investment property. The formula I use when valuing property is the rent potential should equal the mortgage payment at 22 year amortization plus insurance and taxes. If the house has to be amortized more than 22 years, it’s a worse than average deal. If it can be amortized for less than 22 years (with zero cash flow), it’s a better than average deal. Let’s buy a house and set it up with $0 cash flow. House price is $500,000 R-E appreciation is 7% Downpayment is $100,000 (20% down for investment properties) Payment is about $1900/mo. Rent is $2500/mo Next year, the rent will increase 5~7%, bringing it to $2650. The additional income will be put toward the mortgage, keeping the cash flow at $0. This process will be done each additional year. The mortgage will be retired in 11 to 14 years, based on the increased payments. Let’s look at the case of being mortgage free in 14 years. We will have taken our $100,000 initial investment and turned it into 1,350,000 over 14 years. Don’t forget, the $500,000 house will be worth $1M at 10 years and $1.35M at 14 years. We now own that house outright. Let’s consider how we got a 13.5X return over 14 years. We leveraged inflation. If we had bought the house outright with cash, we would have turned $0.5M into $1.35M over 14 years. That’s a 7% return. We averaged 20% by using inflation as a tool. Further insight will reveal that we could return even more by keeping the house leveraged as much as possible. As the mortgage is paid off every 5~7 years, the house should be re-mortgaged for downpayments on additional houses or investments. In this manner, the actual return can be far higher than 20%.
This is why it's far better to own an appreciating asset than it is to have cash. Cash is a peasant. Appreciating assets are king.
