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.
Our plan is to gather as much cash as possible before big inflation strikes, to wait until the Government responds by raising interest rates, and once rates peak to invest with both hands.
You’ve got to plan ahead because it’s not always easy to raise cash. There are some assets you’d have a hard time borrowing against and you may not wish to sell, like grandma’s sterling tea service, the one you got while she was in Shady Acres Rest Home and that your sisters have been looking for ever since. Other assets you could easily collateralize and get an immediate 50 cents on the dollar, but the interest rate would be onerous. A margin loan on blue chip stocks comes to mind. Overall, you could probably generate the most money at the lowest rate by borrowing against your income property. The interest rate is, right now, historically favorable but qualifications are tightening and, over the past year, it’s become harder to get a loan funded.
Three reasons to refi come immediately to mind. First, even if we don’t pull any cash out we’ll still very likely reduce our payment. Going from a 5.5% rate to 4.5% on an $800,000 loan reduces monthly payments to $4,054 from $4,542. Over 360 months that’s a savings of $175,680, which is better than setting your hair on fire.
Second, if we expect inflation to soon begin climbing and our current mortgage is beyond the pre-pay penalty period (income property loans typically have an initial period when there’s a financial penalty for pre-paying on the principal) refinancing will lock in favorably low payments for several more years. That’s a good thing.
Third, during the early fixed rate period we’ll be making our payments with increasingly cheap money. After all, inflation doesn’t mean prices are going up, although it sure seems that way. What it really means is that the value of the dollar is coming down. Inflation is the erosion of the dollar. Nothing more, nothing less. It takes more dollars to buy the same orange. Last year we could buy 100 oranges with $100. This year, the same 100 oranges cost us $108. Inflation eroded the dollar 8%.
If the bank would accept oranges instead of dollars, each year it would take 8% fewer oranges to make the same (fixed rate) mortgage payment. Obviously, if we’re servicing the same debt with fewer oranges, the value of the debt is going down: the debt is being eroded by inflation. Nowhere on our loan statement will it say “we’ve adjusted your balance for inflation, so please pay with 8% fewer oranges this year”. At 8% inflation, after 10 years, the present value of the debt would only be 46% of what it was. We won’t notice the reduction. We’ll only observe that our rents go up 8% a year while the debt remains constant, but it’s really the same thing.
The concept that inflation measures the erosion of the dollar is useful not only to us (borrow now, pay back with cheaper dollars later) but also to governments. It’s not just that as the dollar erodes, the world is more likely to buy more of our products – our products become cheaper and cheaper – and that improves our balance of payments ratio. All those fixed rate bonds we sold to Asian nations we can now repay with fewer and fewer oranges. You have a $1,000 U.S. Government bond? At 8% inflation (erosion of the dollar) after 30 years we can redeem that $1000 bond for the equivalent of $99.38 in today’s money. Sorry about that, China!
Please reflect on that last paragraph. Therein lies the key to reducing national debt, improving our balance of payments, and even increasing net tax receipts. While it’s too bad for bond holders and pensioners, is there anybody who still thinks – show of hands – that it’s not in the government’s interest to inflate the money supply?
This is only for fixed rate loans. If you have a variable rate loan, which shifts the burden of inflation to the borrower from the lender, forget all the above. None of it applies, Buttercup.
Refinancing is not, however, for everybody. You may be so far along with your mortgage that you’ll have it paid off in five or six years. If this is you, you probably don’t want to start all over again. You may have an old loan with a cap (the highest interest rate the bank can charge once your loan shifts to a variable rate) in the single digits. If this is you, you probably don’t want to enter an inflationary period with a significantly higher cap. You may have reduced circumstances with inadequate reserves. If this is you, it’s unlikely you’re going to get refinanced – remember that new Global Debt-to-Income standard we’ve talked about? That’ll sink your application for sure.
But if you could refinance and if it was appropriate for you, this is probably the time to do it. You’ll lock in remarkably favorable rates for a number of years. You’ll benefit from owing money in an inflationary period. You’ll be ready, as Baron Guy de Rothchild advised, to “buy when blood is running in the streets”.
And exactly when might that be?
At first, during the early years after inflation takes off, there will be in government circles and on MSNBC a sigh of relief. Exports increase because the dollar is cheaper. Fixed rate debt can be repaid with cheaper money, so those super-secure government bonds you’ve put your 401K into will buy you fewer and fewer oranges. Folks are pushed into higher tax brackets because they get “cost of living” raises to offset inflation, but the tax brackets are not similarly adjusted. The appearance of prosperity exists. If you’re Chris Matthews, what’s not to like?
Sadly, inflation eats its children. If this year the inflation rate is 4%, next year it will probably be higher. Everybody who got nailed with 4% this year will demand not only to make up the loss but to overcompensate for whatever inflation they anticipate next year. Four percent inflation generates demand for seven percent wage increases. The feeling is, “Somehow I’ve got to get ahead of the price curve, whatever it takes”. The problem becomes self-perpetuating.
It’s said that stocks are an inflation hedge because companies can raise prices to offset inflation, but that’s true only in the long run. In the short run, companies sell in arrears and buy on spot. Think about it, the Widget Company signed delivery contracts last year to provide widgets to the widget jobber this year. But they buy the necessary material on the current (spot) market. It now takes 4% more just for the materials to manufacture the widgets to fulfill last year’s contact. What happens? Earnings go down and the stock price follows.
There’s more. You know that million dollar computerized lathe they just bought? The one that could be depreciated, for tax purposes, over 10 years? In ten years it’ll cost almost $1,480,000 to replace. You’ve reserved one million dollars of that through the depreciation allowance, but where does the additional half-million come from? You guessed it: earnings. The stock takes another hit.
Several years along inflation has, well, inflated to an unforeseen degree. Nobody really thought it would get this high. The market has tanked and everyone’s 401K is underwater. Companies are not making capital equipment purchases and they’re laying off experienced workers, the ones on the higher pay scales. Got to get those earnings up somehow.
OK. Inflation is starting to hurt and it’s time to stop it. We’ll have to raise interest rates. Crank them up 1% a quarter until folks can no longer afford to borrow. Less demand means less inflation. Yeah, that’ll work. Three years along and rates are 12% higher and inflation has noticeably slowed. Two years later, with rates north of 20%, the economy has stalled out. Nobody’s buying. Prices are dropping just to get rid of accumulated inventory. It’s time for the government to announce that rates have peaked and cost of money will be brought down.
Take a sip of tea and think about that for a moment. It’s what Reagan did, so it’s nothing you haven’t seen before. And you know who got Croesus rich during the subsequent generation of declining rates? Everyone who bought increasing streams of net income. That’s just another way of saying “apartment buildings”. An apartment building is nothing more than a stream of (hopefully) increasing net income. You try to raise the rents a little faster than expenses, and your net goes up. Interest rates go down, but rents go up. It’s a beautiful life.
For illustration, say you are looking at 10 units generating a Net Operating Income [NOI: Gross income after vacancy allowance less costs of operation (generally, Taxes, Utilities, Management, Maintenance, and Insurance)] of $5,000 a month. Actual rents are $10,000 a month, but vacancy and TUMMI consumes half of the gross rents. Furthermore, assume cap rates equal to whatever the interest rate is. When interest rates peak, those ten units are generating $60,000 of net income annually and interest rates are 20%. Thus, in this example, the building is worth $300,000 ($60,000 divided by 0.20). You remember when interest rates were 5% and the building sold for $1,200,000. Now the bank’s got it, and it’s been sitting on the market, lost among the other foreclosed apartment buildings — all of them had variable rate loans, you know — and you think you might take a chance with those 10 units. You can do it because back in the Spring of 2011 you refi’d your existing fourplex with a long term fixed rate loan and pulled out as much money as they’d let you.
I know you, you won’t do this, but let’s say you made a full price offer. Hypothetically, the bank accepts. You put $75,000 down. You now have a ten unit building generating $60,000 NOI. Interest rates begin to trend down and in a couple of years they’re at 16%. There’s still a little inflation, and you’ve been beavering away raising rents and your NOI is now at $70,000. Your building is worth $437,500 ($70,000 divided by 0.16). You owe $225,000 ($300,000 minus your down payment of $75,000). You pull out almost $212,500 (minus my fees, I’m not a charity, you know), recovering your $75,000 down payment and another $137,500 to boot. You take your cash-out and buy a 14 unit building. Your present building bought your new building. You pay more for this building than you did for your 10 units because values have gone up a little as rates have gone down. Wash, rinse, repeat.
Some investors we’ve been working with the last ten or twelve years started with a triplex in the early 1980’s or a little later. By following the steps we just talked about, a couple of them have over 100 units. The least among them has 50. All of them kept their day jobs, did the program, and then repeated. Each of them wound up independently wealthy. And just from a triplex, for heaven’s sake! Lawyer required disclaimer: your mileage may differ.
But there are reasons why you may wish to invest right now and not wait until interest rates peak. One of my people – a 100 unit guy – recently did just that. He had good reasons, and we’ll explore some of them next month.
Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email at [email protected]