5 Ways to Make (or lose) Money With Investment Properties – Part 3 – Inflation

by Mr. Cheap

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Go the first post in the 5 ways to make money with investment properties series.

Inflation

In most investments inflation causes you problems. With real estate investing its your friend in a major way.

Inflation is measured by taking an imaginary basket of goods, and figuring out what they’d cost at different points in time. If the purchases would cost more then they would have in the past, the difference is the inflation rate (if it costs less, the difference would be the deflation rate). How much inflation affects you depends on what you typically buy and in what amount. If you don’t drive, clearly the gasoline component of the “basket” wouldn’t affect you as much as it would affect drivers (it will still affect you as increased gasoline costs will get passed along to consumers in the price of any items that requires gasoline for production or distribution – e.g. anything you buy that’s made in China or if you buy a bus tickets to go to Calgary).

House prices (or at least housing costs generally) make up a large part of the inflation measurement. Therefore, house prices and inflation are strongly correlated (some could argue that increasing property values is one of the driving forces of inflation and that house appreciation and inflation are basically the same thing).

Say we buy a house for $100K, get an interest-only mortgage and inflation is 3% over the next year. How much do we expect our house to be worth? In “real” terms (inflation adjusted) we’d expect it to still be worth $100K in todays dollars. In terms of future dollars though, it will actually be worth $103K.

So we now see that without doing any work, our real return on the property purchase is roughly the inflation rate (3%, or a real return of 0%). Since GICs give a real return of 1%, this isn’t too shabby!

It gets better though.

Since we have an interest-only mortgage and have been paying the interest (part of our cost of living, for simplicity’s sake lets say the interest, utilities, maintenance and taxes are equivalent to what we’d pay for rent and ignore them). After a year the mortgage is still $100K (since we’re paying interest only), however, after that’s adjusted for inflation, the $100K mortgage is only actually worth $97K to the bank (money in the future is worth less then money today).

Once we remove the speculation element from real estate pricing, we can clearly see that part of our return from the property is:

rate of inflation * (property value + outstanding mortgage).

Or, in the case of a 100% interest-only mortgage, double the inflation rate times the property value.

Not too shabby at all!

Most of our methods to make money with real estate can backfire and cost you money. Clearly the speculative element of price appreciation is totally beyond your control (or ability to predict), however this is one of the nicest returns, because as long as we have inflation (I don’t think its going anywhere soon), you can pretty well count on this portion of your return Extended deflation would be the negative risk of this portion of the returns – however, again, I can’t imagine a situation where that would happen here in Canada. If it did we’d have worse problems then poor real estate investment returns.

See the next post Taxation.

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{ 2 comments… read them below or add one }

1

Great posts!

Unfortunately, there are places in Canada where home values have not increased. We’d be lucky to get what we paid for for our rental property 4 years ago. Our realtor has informed us that our primary residence would likely sell for less than what we paid 3 years ago (after putting in a new furnace / AC). It wasn’t that long ago that people here were shocked at what their house was worth (in a good way), kind of like I keep hearing from friends in other cities (i.e. Toronto & suburbs).

I just think it’s a scary time to put too much emphasis on appreciation. For a rental property, I would be most concerned about cash flow and value. Appreciation would be icing.

2

I live in Windsor, so job losses (as you mentioned) have been a big factor here.

I actually don’t worry too much about the price of our principal residence. I’m certain that we made a good decision to buy a small house in an ok neighbourhood that was more than affordable for us. The longer we can stick it out the better (though my husband wants a garage and I want a pool – neither of which could fit on our property). Believe it or not, we do catch some flack for living in a ‘starter home in the hood’ but I rather like our $100k mortgage and the house has a lot of character. We have another advantage in that our “Jones’s” aren’t hard to keep up with. :)

Your point about what the cost to build was compared to current price is an interesting thought. I’m not sure on how to find that info though as the house was built in the 20′s.

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