We’ve been told to fear deflation. The government, the Federal Reserve, the mainstream media, and the mainstream economists are all in agreement. They are all alarmed that deflation would ruin our lives. Such myth has been alive since the Great Depression when Keynesian Economics have become the status quo. But buyer beware. Such myth could be just a fallacy.
My short article is not meant to describe the overall impact of deflation on the economy. I’d leave that for the true free market economists (Austrian economists). My goal is to describe important aspects of how the long term real estate investor would be impacted by such an event. It is not an answer to all possible effects but to the most common ones.
In a deflationary event prices drop which may cause rents to drop, as well. This may cause concern with the investor but such concern should be directed by the net cash flow instead of the gross generated income. When real estate prices drop the assessed value on which property taxes are computed drop, albeit not right away. In a healthy deflationary trend, when there is no central bank money inflation policy intervention and no government regulations/restrictions in the insurance sector, the cost of hazard insurance will also drop. The majority of the rest of other expenses associated with the ownership and management will also be adjusted down with time. What truly matters to the investor is what his profits are.
When his profits in a deflationary climate are maintained at the very minimum to what they were prior to deflation, the investor is in stronger position because his standard of living goes up. To give you an example, if the investor’s net monthly cash flow is maintained at $5,000 before and after deflation, his $5,000 can now during/after deflation buy more goods and services. In other words, his daily cup of coffee will cost him less, his wife’s grocery goods will cost less, he’ll pay less to fill up his vehicles’ gas tank, etc. He can now save more money and if he chooses to purchase more real estate he can do so at a lower price.
It could very well happen that an investor’s profits could not be maintained during the deflation. The $5000 monthly net cash flow goes down to $4,500. While this may cause anticipated concern, the investor will soon realize that his personal cost of living will go down thus his lifestyle won’t be negatively impacted by a lower cash flow from the property.
All of the above explanations apply ceteris paribus. One factor associated with real estate deflation is people loosing their homes. The foreclosure process and the foreclosed homeowners’ inability to immediately purchase another home lowers the real estate investor’s risk of vacancy. The foreclosed folks would have to either move in with relatives or rent a home/apartment. The banks’ foreclosure and resale process is lengthy. Both events are likely to create a shortage of available rentals. Shortages, when demand stays constant or goes up, are associated with price increases. This is what happened in 2008 after the real estate bubble burst. While we may not have experienced a true deflationary economy (due to government’s intervention in the insurance sector and the Federal Reserve’s interference by expanding the money supply) real estate investors have benefited through rent increases and high occupancy levels.
What I have described above are reasons to ease the real estate investor’s mind if real estate is to experience another deflationary event. Such theory, based on my interpretation of the Austrian School of Economics, is built on the assumption that the property is owned free and clear. There is one other factor which plays a key role in the investor’s profitability during deflation. The cost of borrowing money, which is detailed enough to be described in another future article.