This article was posted on Friday, Mar 01, 2019

Continued from Part 77 . . . In Emily’s mind, apartment investments are by definition secure. Banks don’t lend $1 or $2 or $3 for every dollar of down payment the buyer contributes if the investment is risky. But, of course, not all apartments are equally secure. We’re using “secure” in the Buffett sense, meaning that barriers of entry make it reasonable to expect a steady and increasing stream of net income and the property is likely to appreciate over time.

 Both net income and appreciation of an apartment investment are heavily impacted by its location. Given a favorable political environment, a poor location for income property is someplace nobody with any money wants to be. Obviously, that means that a better location would be where lots of financially secure people want to be. So the first thing Emily looked for is how crowded the area is: she googled for population density by zip code.

After density comes income. Is it better to own in an area where all the people are rich or where they are universally poor? (Google for census data and look up per-capita income.)

So at this point imagine that an investor discovered a promising area that has a high population density and every person there is a trust fund baby who doesn’t care how much the rent is because the trust pays for it. Is that a good location? Almost.

There is also the matter of building restrictions. There must be significant restrictions. Not rent restrictions, building restrictions. If other investors can build new apartments to meet increased demand, growth in rental income will be disappointing. A good location for investing purposes is a place where population grows faster than the supply of apartments. That means area rents will go up faster than they would in an area with fewer building restrictions. It’s supply and demand at work.

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Overview:  If values go down as rates go up, as we think will happen, and if we’re in a period of rising interest rates, as we think we are, then it becomes important to find ways to offset some of the lost return. Using leverage to help manage the effects of inflation is one possibility.

Generally speaking, investments offer only a few sources of income (i.e., the tenant, Henrietta, either pays her rent or she doesn’t) but many risks. The risks include inflation, which is good for a borrower but bad for a lender, and also deflation, confiscation, and devastation. Separately, there are various market hazards. Put on a scale, most amateur portfolios seem to carry exposure out of proportion to their benefits. Perhaps that’s why an awful lot of homegrown investors earn less than the S&P 500 index would suggest.

What makes some investments work is that the risks are (a) not all equally likely and (b) not all equally consequential. The persistent risks (inflation, confiscation) are manageable and the occasional risks (deflation, devastation) are rare.

Inflation: What do you do when you have a kilo bar of silver worth 80 hamburgers, but only one hungry child? You return to your kitchen and turn the bar into 80 small circles of silver, of course. And while you’re waiting for the melt, you might think, “How does the cashier know my silver disk is really 1/80th of a kilo? Maybe I could adulterate the molten silver with a bunch of nickel and make 160 coins out of the silver bar. How will the cashier know?” And, at the cottage level, that would be the beginning of inflation: the next hamburger will be purchased not with 1/80th of a kilo of silver, but with 1/160th. Mark-ups like that made seigniorage such a profitable enterprise that governments quickly saw the potential and immediately reserved to themselves the right to adulterate the money supply. On the principle that if a little is good more must be better, silver and gold coinage was eventually replaced by paper money and inflation rose to the industrial level. What cost $45 in 1917 cost $1,000 in 2017. Industrial level inflation, indeed!

Helpful:  Properly managed, inflation can significantly benefit the borrower. For such a thing to happen, inflation must grow to exceed the interest rate on the mortgage. As an example, if a mortgage rate was (hypothetically) 5% and the inflation rate had grown to 8%, it’s pretty clear that the borrower would benefit 3% by having borrowed to buy an income producing asset. What this might look like in dollars would shock the innocent.

As an example only, consider that an investor buys a $1,000,000 property with $250,000 down and a mortgage of $750,000. Thirty years later the property is paid off and sold the very next day. Adjusted only for a 4% annual inflation rate, compounded over 30 years, how much did the property sell for? What was the investor’s gain? What was her yield?

Math: Sales price:  $1 million compounded at 4% for 30 years equals $3,250,000. The property sold for 3.25 times the earlier purchase price. Gain:  Subtract the down payment of $250,000 (that was the investor just getting her own money back) and the investor’s gain was $3 million. Annualized Yield:  For $250,000 to grow into $3,000,000 in 30 years requires an annual compounded growth of 8.94%.

Excuse me? The investor’s yield, over 30 years, was more than twice the rate of inflation? Yes, due to properly managed leverage. The investor benefitted from the entire purchase price ($1,000,000) inflating at 4% annually, but she had only $250,000 of her own money at risk.

In this example, during the first year of ownership, a 4% percent inflation rate would raise the $1,000,000 property to $1,040,000. The investor would have made $40,000 on her down payment of $250,000. Her gain would be 16% ($40,000 divided by $250,000).

All of that inflationary growth belongs to the borrower. The lender gets bupkes. Properly leveraged investments, especially in an inflationary environment, can generate profits that would make your mother-in-law take your side against her own son.

Hurtful:  That same situation of inflation exceeding the rate of interest is disastrous to the lender. To revisit the above example, a loan made at 5% when inflation is 8% constitutes a 3% annual loss in purchasing power to the lender. In an industry that measures return by basis points (there are 100 basis points in 1%), an annual loss of 300 basis points (3%) is no laughing matter. To reduce this possibility the lender will try very hard to transfer as much of the inflationary risk as he can to the borrower.

Incentivizing the borrower to accept the risk of inflation is accomplished in a variety of ways. The lender may seem to compromise by offering a loan with an initial fixed rate period during the first five years of the loan, or seven or perhaps even 10 years. This is expressed as “It’s a 30 year loan, fixed for five”. Another way is to cap the interest rate at some level above the starting rate. “This is a 5% loan, and the very most the interest on this loan can go up to is 11%! There’s a six percent life-cap!” Or the lender might say, “The regular rate is 5%, but we’ll give it to you at 4.75% if you go for our no-fixed-rate program.” Yet another alternative is when the loan is a 10-year “bullet”: the interest rate may be fixed during the life of the loan, but the loan becomes due before it’s paid off. The balance owing must be refinanced at the then-current interest rate. In each of these examples, inflationary risk is transferred (in whole or in part) to the borrower.

Government:  The government is the market’s largest borrower. It is expected to borrow $1 trillion this year. As inflation benefits the borrower, so does the government benefit when it’s the borrower. Consequently, the government has a beneficial interest in inflating the money supply. Inflation is therefore both likely and (compounded over time) consequential.

Impact:  The lenders in government paper are the individuals and institutions who buy government bills, notes, or bonds. Since these things have fixed interest rates (some exceptions), the consequences of inflation are suffered by the people who buy the debt (the lenders). This can be harmful to their wealth.

Example:  Right now the market yield on a 30 year Treasury bond is 3.00%. Presume the buyer’s marginal tax bracket (combined state and federal) is 35%. That brings the after tax yield to the T-bond buyer to 1.95%.

But now the buyer must adjust for inflation. On the day this is written, the local inflation rate, as measured by the Consumer Price Index is 3.20%. It’s important to get one’s arms around those numbers: after-tax yield of 1.95% against an inflation rate of 3.20%.

The unfortunate buyer has agreed to lend money for 30 years at a return (net of taxes and inflation) of negative 1.25% per year (inflation rate minus after-tax return). The net present value of a 30 year loan losing 1.95% per year (compounded) is 56% of the amount originally invested. This shows why the government is so devoted to inflation: It only has to pay back (in inflation adjusted dollars) a small portion of the amount originally borrowed. In this example the inflation adjusted payback is 56 cents on the dollar.

Lending:  Notwithstanding the potential for inflation-related losses, there are many reasons to buy bonds. An obvious example might be when a major expense is expected in a couple of years (grand-daughter’s wedding, etc). The investor has the money now, but doesn’t want to put it into stocks because the market may be down when the debt is due. In that case, putting it into bonds makes sense. Her losses will be minimal and she’ll have the funds when they are needed.

Or, given that her stock portfolio backs up her income property portfolio, she recognizes that bonds could be used to back up her stocks. She’s willing to exchange a minor loss to inflation for the security that near-instant access to cash represents . . . and for the ability to draw on her bond portfolio to buy stocks when they are down.

Other reasons will occur. The point of this discussion is not that bonds are never useful. The point is that there’s seldom much net yield left after deductions for taxes and inflation. There are times, though, when that is an acceptable position.

The “Can’ts”:  The thoughtful borrower recognizes she can’t expect to borrow institutional money at less than the current rate of inflation. It’s different from mommy and daddy. They’ll do almost anything to get her out of the house.

The “Can”:  In our mortgage business we like to have our clients understand that if the trend in interest rates continues upwards, it’s probably better to refinance now than to wait and watch rates rise and refinance sometime in the future at an even higher rate. It’s possible that whatever interest charges are today will look really good in a couple of years.

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

This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional. Klarise Yahya is a Commercial Mortgage Broker specializing in difficult-to-place mortgages for any kind of property. If you are thinking of refinancing or purchasing real estate Klarise Yahya can help. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected].