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***please read: The first section of this blog is fairly long and explains the background needed to understand the other sections. If you don't need the help of the definitions, please fast forward to the end.
Definitions
Supply and demand are terms you must have an understanding of in order to take control of your own economic situation. For those new to this concept I will explain quickly here. I will give an example rather that giving definitions here because a real life example makes more sense of this phenomenon. If you live in a growing city where there are a lot of new jobs, but the city doesn't have enough housing for all the new immigrants who want these jobs the price of the houses will go up. This is because supply is low (the houses) and demand is high (the people who want to purchase these houses). The reason the houses will move up in price is because when a house goes up for sale, maybe 2 or 3 people will attempt to purchase the house and the highest bidder tends to win. In Calgary around 2005-2007 there were annual increases in house values by over 35%! At that time if a house came up for sale, within a few hours there might be 10 families interested in that house, which drove prices extremely high in a very short period of time. The opposite is also true. If you live in a small town that had a main employer move somewhere else, there are now people leaving the town, not coming in. What this does is drive the prices down in that area. The supply (houses) is high and the demand (people wanting to buy these houses) is low. Every time a house comes up for sale it might sit like that for a few months or even a few years. In order to sell the house, a family will be willing to lower the purchase price, but now that seller is competing with other people trying to sell their houses quickly and the opposite of a bidding war begins. Each family will try to lower their house quickly enough to sell it fast rather than keep a house in that town AND own a house in the new city with jobs.
Inflation is a normal part of everyday life in North America. A simple understanding is basically that when money is printed supply and demand kicks in and fiat currency is devalued; when a government prints more money and sends it into the economic system, there is more supply (money), but demand will suffer somewhat and this devalues the buying power of each individual dollar. Official government sites tend to talk about the rate of inflation as under 3% annually for the last 20 years. Many people take issue with this reporting of inflation, however, because the CPI (customer price index) that measures how much inflation is taking place does not account for everything that people are buying, so it is skewed to the low side. Many people believe the real rate of inflation is actually about double what is reported. I will leave you to be the judge of your opinion, but as a starting exercise you can quickly look at how much money you are making now compared to how much it costs to live (I'm talking about basic living expenses in Canada like rent, groceries, gas, etc.)
Deflation is the opposite. This is when the stuff we need on a yearly basis actually decreases in price. Another way to understand deflation is when money in an economy becomes more valuable. This can happen for a number of reasons, but the most common are: 1) when the people of an economy don't buy enough goods. When people start saving money instead of spending it, the cost of goods comes down and 2) if the pace of population growth is greater than the rate at which money is printed. Again, this is easy to understand with a basic understanding of supply and demand.
Governments are terrified by deflation. Why? Because if the currency is worth more each year it means the debt that country owes to other countries actually increases on top of the interest rate. This is actually the main reason countries print enough money to keep inflation rates 'healthy'. This is really important to understand because governments have a crazy amount of control over their own debt up to a point. If a country, like the US, starts getting into trouble with how much debt they owe other countries they can begin printing money at a faster rate. This causes inflation (devaluation of the dollar), which in turn helps in paying down the debt for two reasons. The first reason is that the value of the debt in year 1 is higher than the value in year 5. I'm not sure I want to explain all of this here because it will get wordier than this blog already is and I still have to make my main point! A simple explanation is that if you have an inflation rate of 6%, the value of the dollar will decrease by half in 12 years. So... if a government owes 1 trillion dollar to another country and can devalue their currency by 6% per year, they will only owe 500 billion dollars after 12 years. The other reason printing money helps in paying down debt is that there is little initial cost to the government for printing this money and paying down the debt. If a country owes 1 trillion dollars it could simply print 1 trillion dollars and pay of the debt. A country has to be careful, however, because if it prints too much money, the money won't be worth anything and the economy will suffer in other ways.
Some people ask me: how can the US possibly get out of the debt they are in? The answer is simple. The US government will attempt to devalue its currency to help manage the debt load. They have been doing this for the last 5+ years with 'Quantitative easing'. The numbers are mind boggling. I don't have any definite numbers, but some people claim the US has printed over 10 trillion dollars in this time. What does this mean for the economy in the near future? That there will be inflation rates much higher than 3%.
Fiat currency is important to understand as well... Fiat currency, for our purposes, is simply paper money. The money doesn't have any value in itself other than the cost of the paper (or plastic now in Canada). The value of fiat currency is in how much it represents and whether or not people trust its worth. A commodity of any kind is not fiat currency because it has value in itself; intrinsic value. This is why gold and silver are spoken of as good currencies by some people; they are valuable on their own no matter what value is placed on them by a government.
Today's market
As I just mentioned regarding the situation in the US (a similar situation is happening in Canada because the US economy influences us greatly... Maybe I'll take the time to explain that in another blog), we are at the beginning of a highly inflationary market. For any individual in the US or Canada the wage you will be paid in the next decade will not grow as fast as the price of goods. This is scary, but you can take steps to avoid big problems.
The best thing you can do in this type of economy is to have all of your savings in commodities. Some people purchase gold and silver or other precious metals, but I invest in real estate. The worst thing you can do in this type of economic situation is to save dollars. Even if you save dollars and receive an interest rate of 3% (hard to find these days at any bank), if the rate of inflation is at 6% it means your money is actually shrinking by 3% per year. I highly recommend finding better ways to save money than putting it in a bank. The practice of saving money by purchasing commodities is called hedging. If you buy a hard asset (gold, silver, a house, etc.) then inflation doesn't affect this asset negatively. If inflation goes up by 5%, then the cost to purchase the house you have also tends to go up around the same amount (keep in mind I am simplifying these concepts so I can get to my main point somewhere in this blog:). Paper assets (stocks) are not a hedge against inflation because they can go a completely different direction than inflation. It's true they will tend to go up as inflation rises, but they are disconnected from intrinsic value (their worth isn't tied to commodities. Some may argue they are tied to businesses, but this is debatable because as companies increase or decrease in value the stocks of these companies are governed instead by public opinion of the stocks themselves which is why a company can have a great year and yet their stock tanks).
Quick summary so far...
The rate of inflation is most likely going to increase in the next few years, but even if it doesn't the way to hedge against even normal inflation is to have your savings in physical (hard) assets rather than fiat currency. In an inflationary market your paper money is devalued. In a deflationary market your paper money goes up in value (you can buy more with each dollar). What should you do, then? Should you invest in gold hoping the economy won't do well? What if the market doesn't realize high inflation but rather deflation? What could you do in that situation? This is where another beautiful aspect of real estate comes into the picture.
Profit from inflation AND deflation
When the government prints money inflation happens, but deflation is consistently taking place as well in certain sub markets. An example is computer technology. Do you remember how much a 286 PC computer was costing 20 years ago? It was thousands of dollars and all it did was crunch numbers. Now we have quad processors that can do almost anything we can imagine and yet they cost a measly thousand bucks! At times, the real estate market is devalued for a period of time (think 2008 and 2009). This provides a fantastic opportunity to purchase real estate. Not when real estate hits its low (you'll never be able to gauge that until after it has passed anyway). Purchasing real estate on the down swing (a buyer's market) is an ideal time to make money. When you have purchased this real estate you now are in a position to not only hedge against inflation, but make money (quite a bit of money) from it. If you purchase with borrowed money (a mortgage), then you can pay back this loan with depreciated dollars. In the late 70s and early 80s, this was how much of the baby boomer generation made hundreds of thousands of dollars. When inflation rates hit 6% or higher and you are paying off debt at 3% you are making 3% simply by holding the loan. On top of this the money you owe is being devalued each year so that after 12 years that $200,000 that you did owe is now worth $100,000 and you are being paid more nominal dollars in wages as well as collecting more nominal dollars in rent. Wait another 12 years and if inflation continues at 6%/year you will owe $50,000 even if you were only making interest payments.
If you understood what I just wrote you are either an experienced real estate investor that understands the depth of how real estate works for owners or fireworks are going off in your head right now thinking of the possibilities!
So.. what now?
Don't get me wrong, I won't only purchase an investment property in a buyer's market. I will look to purchase a property whenever it's a great deal (notice I didn't say 'good deal'), but when the market is falling I realize there is even more money to be made from other dimensions of real estate. The reason I present more and more dimensions of real estate is to teach anyone who will listen that real estate is as close to a can't miss investment if it is done properly; when you cover your risk by capitalizing on each and every profit centre.
If anything wasn't clear in this blog or you want to learn more please email me: mfrentz@akerahomes.com and I would be happy to call you and explain anything you are desire to understand better. If you live in Calgary I'll even buy you a coffee so we can sit down for the chat.
Have a fantastic week!
If you would like to learn more about investing in real estate please contact me at the email address listed at the beginning of this article or go to my website at: www.akerahomes.com/investing-in-real-estate.html
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