Part 2: An amateur property investor's guide to navigating inflation

by Nick Gentle on Apr 05, 2022
Article appears under: About Property Investment, Investment Strategy, Mortgages, The Numbers

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Welcome to the second part of this series on inflation, where I try to take the various strands of how I think about this messy topic and put it down on paper. 

In part one I looked at what inflation is, why it is happening and how it typically affects property. Please check out part one if you have not yet read it.

Below I dig into the long-term benefits for investors who can navigate through the short-term turbulence that inflation brings to any market.

We look at risks more specifically, I share what I did to control the outcomes that I can, and I present some simple ways to think about whether you should buy or sell in this market.

Ultimately what an investor does in response to change depends on their own circumstances, what information they seek out, how they think about risk, how much they are driven by emotion, and whether they take a short, medium, or long-term view. 

In saying that, most folks don't spend nearly as much time actively investing, discussing, and analysing the property market as I do, so if you feel lost in all the recent news about property, interest rates, and inflation, then I hope it gives you a bit more of an overall picture. 

This is how I think with regard to my own investing and I am not an economist or financial advisor. Please seek your own advice from suitably qualified professionals.

The benefits to investors who navigate inflation

Before I get into this next part, note that there is inflation and then there is inflation... I mean the difference between prices increasing at a measured pace and a sudden rapid inflationary spiral, or worse, hyperinflation.

We as a society adapt to what we know is coming so a gradual increase in prices doesn't make headlines, whereas a more rapid increase in costs catches consumers and businesses by surprise, leading to sudden changes in behaviour and risks to jobs.

All that said, there are a couple of benefits from inflation for the investors who successfully navigate such periods.

Benefit #1: The erosion of debt

This is the big one.

Remember that at the start of this article we defined inflation as the decline of purchasing power of a given currency over time?

Well the dollar amount of your mortgage will never increase after you borrow the money (unless you borrow more) so the purchasing power of that amount also declines. Over time your debt starts to appear cheap.

Example

Borrow $500,000 to buy a house, put your loan on interest-only, with inflation at 5% and your house covering its holding costs.

After year...	Relative value of debt is...
1	$475,000
2	$451,250
3	$428,688
4	$407,253
5	$386,890

After 5 years your mortgage is still $500,000, however, what that $500,000 is worth (can buy) in the real world will be very different from when you bought the property.

That manifests itself in the future as capital gains. There is only so much our dollar can devalue before asset prices jump. 

In New Zealand, we tend to get our gains in headline-grabbing bunches, however, those increases can be the market value adjusting to pent-up inflationary and demand pressure.

Offsetting this is that the COST of your debt (interest rates) will usually increase, so unless you actively manage your loan structure, the increase in holding costs can be painful. More on that below.

I believe in debt erosion because it is the Government's plan

When governments take on too much debt they accept there will be some future pain to even things out... even though nobody will acknowledge it at the time.

The country will have to either...

• Cut spending to repay debt (such as the austerity program the Greek government entered into, triggering massive protests)
• Increase taxes,
• Pay it back in the future 

Important: Inflation has the same impact on a country's debt as it does on our and to "inflate the debt away" means that while the debt pile follows the house example above; It stays the same absolute debt terms but shrinks in real-world terms and is easier to repay in the future.

Why is this important?

While no politician will ever say they will rely on tomorrow's inflation to cover up today's shopping bill, it is implied, and those of us who also carry fixed interest debt can go along for the ride. 

A billion dollars isn't what it used to be...

Benefit #2: Rental income goes up

Rents tend to increase during periods of inflation, particularly as wages, benefits, and allowances rise... another case of more money chasing the same limited amount of stuff. Landlords also have to allow for higher fixed costs.

Rent increases as a result of wage increases tend to be permanent - supply/demand dynamics in your area non-withstanding. So the income you earn from a property will go up while your debt on it doesn't. 

Risks investors have to navigate

While our debt being worth less and our assets earning more in the future sounds great, we have to navigate through a whole lot of now to get there.

Here are the big five lumped together with an example.

1. Interest rate rises - we have already seen this and there is still upward pressure.
2. Other cost increases - check your insurance bill lately? 
3. Political responses - interest deductibility changes (yuk)
4. Employment and population demographic change - A "brain drain" is a real risk
5. Black swan events - such as the war in Ukraine, COVID

Those are pretty significant and I'm not going to get into quoting various news sources and articles to give more examples of each because that would double the length of this article. If you want to learn more about bad things going on just go to the front page of the BBC or NZ Herald websites and scroll down....

I'm sure you get the idea... lost of risks and we don't know them all. So it is important to control what we can and understand where we need some buffer.

Mitigate the risks

Of the above...

#1: You can control your interest rate costs in New Zealand for up to 5 years. 5-year loans are more expensive than 1-year loans, which is why many owners "took the candy", to quote Tony Alexander, of very cheap rates during 2020-2021, and won't look at what rates are on offer until it comes time to rollover. 

#2 you can control a little by getting on top of your maintenance and reviewing your insurances to make sure you are correctly covered.

#3 we have very little influence over between elections, sadly, other than being vocal in opposition to changes that you do not support.

#4 is important to be aware of and to a) have some slack in your numbers and b) be careful when investing in areas with few main employers

#5 can be difficult to plan for, but it can be done. Not many had a risk plan in for the Global Pandemic... except for those who did. For property investors this means having correct insurance and multiple exit strategies.

How I prepared for the future

My general approach to risk management is:

1. Work out what can really bite me in the ass 
2. Try and stop that from happening

Loans

In early 2021 felt that my biggest risk coming out of the pandemic was a shift in interest rates because they weren't going to go down and long term there was upwards pressure starting to appear.

I carry (what feels to me like) a lot of debt... so I broke many of my mortgages and locked in for multiple years a long time before actual interest rates rose. I had no idea when they would go up, I just figured I wanted to be on the right side of that.

I guess this is called loss aversion and my repayments actually went up. But this has always been my strategy: I want cost certainty and tend to fix for longer periods. This cost me when interest rates went down and I guess in the long run I will break even.

Warren Buffet calls this way of thinking the Noah Rule...

I would do the same again at today's rates

It feels like this inflationary period will be exacerbated by the war in Europe so knowing my largest cost for the next 3, 4, or 5 years is important to me.

I would regret having missed some cheaper rates last year, but we are talking about managing risk, not trying to "win at borrowing".... my loans are by far my largest cost and fixed-interest debt isn't widely viewed as a good inflation hedge for no reason.

Insurance

I reviewed all of my insurances and set the excess amounts a bit higher and nudged up the insured amounts. I view insurance as covering major financial loss and at this stage for me, a repair bill of $1,000 for something isn't worth trying to cover through insurance. 

Sold one property

I sold one property, mostly because it was a stand-alone house and an opportunistic "buy and rescue project". My long-term strategy is multi-income, so this frees up cash to buy and develop properties in line with what has worked for me to date.

Cost of living

I already keep my expenses quite low because I believe Robert Kiyosaki's statement that wealth is measured in time... i.e. if income dried up how long could you survive? I used the money I saved doing this to get ahead and don't see any reason to change behaviour now that it worked.

3 years ago I moved our family from Japan to New Zealand to give my son a kiwi culture boost. Having two bases (we look forward to finally going back to Japan for a spell this year) is enough luxury for me. 

Should I buy now?

If it's a good deal and moves you ahead financially, yes. I don't ever have a different answer to this question. Some people are better than I am at timing the market and leveraging up and down, but I enjoy my not-needing-the-dice-to-break-a-certain-way-in-the-future existence.

One of the interesting things about investing when the market is quiet is that you have more time on each deal to work out your plan. As a hands-on investor, this is more valuable to me than a price swing.

There are worse things to do right now than lock in a great asset when everybody else is looking the other way, fix your loans for a few years and look forward to the value of the debt eroding quickly.

Should I sell now?

Again, same answer as usual:
If you look ahead and see a lot of risk in your cashflow and/or other personal circumstances and don't have a way to navigate through it, I would consider "derisking".  

Other than that, only sell if you have a better use for that money. 

I like to stack risks... say a vacancy, some damage, job loss, and illness all happen at once, can you handle it? If not then look at what cash buffer you can have, add different insurances, or consider selling. A financial advisors can be a good sounding board. 

If you sell, be realistic... if not selling will cause real problems down the track, then don't hold out for top-top dollar because the first offer may be the best and you are selling to remove risk. 

If you can take it or leave it, then of course you can be a bit more selective in what you accept.

In summary

Inflation is scary because once it is "unleashed" it can build on itself and get out of control, which is why central governments often move quite quickly to try and combat it. You need to plan for things being hard in the short term. The news in particular will become very pessimistic and it can be hard to stay rational.

Just remember that while it can be a tough time, inflation will erode your debt and usually will increase your rental income, even as the negative aspects play out. Fixed interest debt is a very good inflation hedge.

The trick is to navigate through the risky period and not try to "win at knife juggling" by thinking too short term.

It doesn't matter what you earn, it matters what you keep.

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