I have been very busy lately with proms, choir/band concerts, soccer and a whole lot of other things going on.  I'm starting to question if this is what "thriving" as a big family looks like.

I've been thinking a lot about all of you owners who put your faith and trust in our company and about real estate prices, interest rates, and inflation recently.  I recently wrote a detailed facebook post where I looked at historical inflation data to model how purchasing power and your effective principal and interest payment (due to that purchasing power) are impacted.

To summarize that very technical post, if inflation averages 3% per year, and you pay $1000 per month for your principal and interest, next year's payment of $1000 per month is only really worth $970 per month (in today's dollars) and then the following year is only $940.90 per month (in today's dollars) and then $912.67 per month (in today's dollars) and then $885.29 per month (in today's dollars).  By the final 360th payment, that $1000 payment is only worth in today's purchasing power $406.12 (in today's dollars).  When you add up all of those corrected payment amounts on a monthly basis (with an assumed 3.5% mortgage rate), the analysis indicates that your effective interest rate is something like 0.27%, instead of the 3.5% as calculated.

In summary, anyone who has a 30 year mortgage at 3.5% interest or less is essentially being subsidized by the loan itself.  Another way of saying this is that because the purchasing power has decreased over this time period, the house at a minimum should be worth 2.46 times more ($1000/$406.12) than what you purchased it for today (if we just assume the house price goes up as the inflation averages 3% over the next 30 years). 

I now have friends buying properties so they can assume the loan and say things like, "The asset is the loan itself, not the property."  I also heard about waterfront homes in Russia with a loan where the loan was wiped out since inflation hit 874% in 1993 and then 308% more in 1994 and then 197% more in 1995 and continued to be high for years after that. - https://www.sjsu.edu/faculty/watkins/russianinfl.htm .  I have seen this first hand as I remember about 30 years ago when my dad bought a house with about 30 acres of land for something like $150,000.  That property and land is worth over $1,000,000 today.  Having patience in the market is how wealth is made.

While I do not think the government will cause inflation to get to this level, if the inflation rate stays high, having leveraged assets that hold value like gold is basically the best investment to get into based on this analysis.  This means that you should try your best to stay out of cash long term, which is why inflation is so difficult to get under control (since purchasing power decreases tomorrow you need to spend all the cash today).  This is also while there can be social unrest because people who live paycheck to paycheck are struggling to make ends meet while people that hold assets continue to be able to maintain a similar standard of living.  

Even at 7% interest rates, if you assume a 3.6% rate of inflation over the 30 year loan (instead of 3%), the effective interest rate is only 1.54% (banks are smart and they know that they need to lend out the money at a rate that is above what will be lost by the purchasing power reduction).

This is the fundamental force of why interest rates are affected by inflation (10 year treasury estimates) and not the federal funds rate.  It also suggests the reason why interest rates go up as the expectation of inflation increases.  All of temporary deflation that occurred during COVID and the talk of transitory inflation, and the federal government holding loans down with their quantitative easing essentially subsidized the house market through lower than should have occurred interest rates.

This leads me to the subject line of this email.  I now realize that the low interest rate that I have (I'm at anywhere from 3.5% to 4.5% for my 30 year loans) is actually the asset for the properties.  I plan to hold them for the duration of the term and to not repay any of the amount owed early.  

As we continue to be a superpower with other countries continuing to want our currency, I think both the Republicans and Democrats will continue to print money, leading to additional inflation.  Additionally, I think over long periods of time, this continued printing will lead us to lose our currency reserve standing with other countries (it's already starting to happen) which should cause us to not be able to print as much (since no one will want to hold our currency).  I think this will cause us to continue to have higher than normal (2%) inflation.  If inflation goes up from here, even a 7% interest rate loan will be cheap.  This is the reason that I do not believe that the federal reserve will be decreasing interest rates anytime soon (if I had to bet, I think there is a good chance we may see an increase in interest rates). 

Thirdly, I think that as a result of all of this, rents have to keep going up.  The government has a challenge on their hands right now to figure out how to make housing more affordable.  Since it is the single biggest expense, something has to give.  Either the government has to figure out how to increase wages (which would definitely be inflationary since everyone would be paid more) or they need to figure out how to make housing more affordable.  Housing providers are in the cross hairs right now and it will be interesting to see what happens.  Do not take anything personally, it is going to get worse before it gets better.

This leads me to thinking how I win if I am right about inflation and win if I am wrong about inflation.  If I can find a great house at a fair price (a little bit of cash flow for safety), I'm going to buy it with a hope to refinance the property years in the future at a lower interest rate (if I'm wrong about inflation).  If I'm right about inflation and it keeps going up, then the asset and rents have to go up significantly (why does a 1 bedroom apartment cost over $3000 a month in NYC - there is not enough housing so people have to move in together to cover rents) to account for the reduction in purchasing power (as described above).  The worst case would probably be that rates do not move in either direction for an extended duration.  In this case, the safety is that you buy an asset that has positive cash flow so you can cover your debt service.

In no way am I advocating to not sell your real estate.  I'm only suggesting that you do not sell any real estate to be in cash but I definitely suggest selling real estate if you can put it into an investment vehicle (like expanding your business).  I have seen a bunch of my friends kicking themselves for selling too early.  Especially in CT, I think this real estate market still has legs.

Reach out if you have any questions about this.  I love to think about the economics of real estate investing.

- Sam Eddinger