Inflation: There is great satisfaction when investments appreciate in value, and a modest celebration is called for. Maybe get your hair done early this month. But before Diana starts the highlights, it is useful to understand that not every new dollar received benefits the investor equally. Appreciation comes in two forms. First, there’s the increase driven by the market, a result of improved demand or reduced supply. This often comes with a good location, defined as real estate located at the intersection of (a) increasing population and (b) insufficient buildable land. Market related increases reflect a change in the investor’s actual purchasing power.
Secondly, there’s the form driven by inflation. That increase carries no net gain in purchasing power. If bananas are 15 cents each and you have 15 cents in your purse, you can buy one banana. Then inflation strikes! Bananas go up to 30 cents each, but, miracle of miracles, the money in your purse has also doubled to 30 cents. You can still buy one banana. Your assets kept up with inflation and your purchasing power remained constant. In the event of properties with no current underlying financing, inflationary increases are actually a net negative because gains due to inflation are taxable events. After paying the (real) tax on the (phantom) gain, there is a net loss of purchasing power.
Inflationary increases are not always all bad, however. On a before-tax basis, they allow the investor to maintain purchasing power over time. While this does not create profit, inflationary gains serve, over a long enough period of time, to insulate the investor against loss through currency devaluation. Currency devaluation hurts the saver while inflation benefits the borrower, but ultimately they are the same things. Which term the speaker is using simply depends on what he is selling.
Bernstein (Deep Risk: How History Informs Portfolio Design, 2013) identifies the four great risks of investment as inflation, deflation, devastation, and confiscation. Inflation is the first and most critical because it affects everyone, everywhere, all the time. And it can be ruinous. At 3% inflation, the purchasing power of $1,500,000 would be reduced over the next 30 years to $618,000 in today’s money. Alternatively, if the investment simply maintained parity with inflation, the spending power would be unchanged at $1.5M.
For an investor, at least maintaining parity with inflation is huge.
Inflation moves in cycles. The government began tracking it in 1913, and between that date and 1919 annualized inflation measured 9.8%. Over those six years the purchasing power of a $10,000 nest egg dropped 46%, to $5,385. The depression started about a decade later, and from 1930 to 1939 prices deflated a little over 2% per year. Sometimes inflation cycles up and sometimes down, but the long term average for the 100 years between 1913 and 2013 was 3.22%. To repeat for emphasis, we have seen what a 3% inflation rate does to $1,500,000 cleverly hidden in the lingerie drawer, where no burglar would look. Thus the question: How about real estate? Does well-located real estate, over the long term, really keep up with inflation? For that we should review the applicable approaches among which value can be expressed.
Estimating Value: There are a number of ways to estimate the value of financial assets. Three are: appraisal based, share based, and transaction based. They all have faults, just not always the same faults.
The appraisal based method has three approaches: (1) the cost to rebuild, (2) the price indicated by recent sales, and (3) the value that the property’s net income will support.
The difficulty is that appraisal based valuation methods are subject to change over time. That weakens the link between an earlier assessment and later ones. As one example, there was a time when toxic wastes were not adjusted for in industrial appraisals: “Of course nothing grows there, Gomer! It’s where they pond their carcinogens!” At that time hazardous wastes were a generally accepted byproduct of the industrial sector and carried no legal consequence. Then came the Superfund Act of 1980, making subsequent owners financially responsible for remediating legacy toxic waste, and that put a quite different perspective on things. Thenceforth the lender, the buyer, and the buyer’s new second wife found toxic wastes most interesting.
Share based estimates might be considered in the case of a building bought for $1,000,000 and owned by three people with unequal interests. Phred put in 42% of the purchase funds. The building is now worth $2,000,000. How much is Phred’s share worth?
Share based methods that might be applied to Real Estate Investment Trusts (REIT) do not lose applicability even though the specific properties owned by the REIT are subject to change over time. The share value of a listed REIT is only a google away.
Transaction based estimates are often employed to good effect by auction houses, particularly when there aren’t enough sales of comparable large sapphires to create a supportable estimate of value. Example: The COVID-19, an untreated 18.67 carat padparadscha sapphire of vivid pinky-orange color, and only a flash or two of yellow, was symmetrically faceted into a cushion cut by Lazare Kaplan during the early days of WW1. No comparable sapphire exists: this is the one and only. The most appropriate way to estimate an auction value for this stone is to track its historical sales and apply a line-of-best-fit solution. “Ok, Lester, the auction records show this stone has sold at twenty-year intervals since it left Kaplan’s workroom. Each time the price achieved increased by 20%. The last sale was 19 years ago, for eleventy-gillion dollars. Think we should just add 20% to that price and see what happens?”
Although imperfect, transaction based methods are perhaps appropriate when the assignment requires reporting historical changes in value and limited data exists. Another example of such an undertaking might be to answer the question, “My cranky menopausal sister wants to know how much that old house has gone up since it was built. Don’t ask me why!”
Transaction based projects require that exchange values are accurately reported and available to the public. Not every municipality makes purchase prices publicly available. When they are not, gathering the data becomes tedious work. But suitable OCD people can be found. “No, I do not have OCD! I have CDO! Mine is in alphabetical order!” Some places are more amenable to detailed analysis of legacy records than others. There are cities in Europe that have been recording prices on building sales for centuries. One of them is Amsterdam.
The late 1500’s, following the Eighty Years War, and most of the 1600’s were Amsterdam’s apogee. It was then, no longer concerned with Spanish warships, that Dutch merchantmen sailed over most of the known world, alert for new sources of rare spices. They returned from Indonesia with pepper, cloves and nutmeg. Nutmeg was, at the time, the third most costly commodity in the world after gold and silver. A sack of nutmeg could make a man wealthy for life. Two sacks would make him suddenly desirable to eager young maidens. One assumes that the two-sack bundles, like Costco now offers with peanut butter, were in high demand. And every season there were large ships, cargo holds fully packed, returning with this stuff.
It wasn’t only Indonesian spices. Contemporaneously, the Dutch East India Company acquired a monopoly on trade with Japan (gold, silver, copper, porcelain), and maintained it until Admiral Perry came knocking in 1854. Naturally, all this going and coming benefited the stay-at-home speculative Dutch traders who underwrote the trips and called triple-dibs on the returning cargos. In this way Amsterdam became one of the richest cities in the world.
Immigration: Great wealth attracted the hopeful. People immigrated to Amsterdam from throughout Europe. Those who became a burden on the citizenry were encouraged to continue their travels elsewhere. Those who had saleable skills were required to meet three conditions of acceptance: (a) to join guilds (demonstrating the immigrant was self-supporting), (b) to serve in the civil patrol (thus benefitting their new city in a meaningful way), and (c) to cooperate with their local municipal district in competition with the other districts during carnivals and parades. Immigrants from diverse backgrounds (Sephardic Jews from Portugal, French Huguenots, German Lutherans) were thus forced to acculturate. Family and friends from back home learned of homeboy’s success and moved to Amsterdam themselves. The city eventually could not contain them all.
(Something to Think About #93: Information, Not Advice Part 13). Continued next month.
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].