“Thus inflation is unjust and deflation is inexpedient. Of the two perhaps deflation is, if we rule out exaggerated inflations such as that of Germany, the worse; because it is worse, in an impoverished world, to provoke unemployment than to disappoint the rentier. But it is necessary that we should weigh one evil against the other. It is easier to agree that both are evils to be shunned.” – John Maynard Keynes

You Might Be Surprised To Learn How a Mortgage Can Destroy Your Real Estate Wealth Through Deflation

If An Economy Suffers From Unanticipated Deflation, Then A. The Real Burden Of Nominal Debts Increases. The Real Burden Of Nominal Debts Falls. The Price Level Increases Unexpectedly. It Becomes Easier For Borrowers To Repay Their Debts. The Value Of Money Falls 2. In The Classical Model, An Increase In The Demand For Labor Leads To. Just like inflation, the government wants deflation to hover around 2-3%. The Fed can increase the money supply through the sale of treasury securities. If the supply of money increases, it becomes less expensive. Every dollar can buy more, driving prices up. The Fed can ask banks to increase the amount of credit available.

This is the 3rd in a series of 4 posts about investing in real estate. The last post, Inflation – The Secret To Building Wealth in Real Estate, is about how inflation is essential to building wealth via your real estate investments. While most people subconsciously understand that real estate has all of the features listed in that post, they may not be sure why real estate has those features. The key is inflation.

This week I will be discussing the other side of the coin, and what happens when there isn’t inflation to make your real estate the wealth building tool that it has been for over 50 years.

This week I will be discussing deflation, how it would affect your real estate investments, and how a mortgage can destroy your real estate wealth. Many notable economists have made deflation the economic boogieman. They have claimed that it is the worst possible outcome in an economy. When you hear someone talking about deflation, it is highly likely that Japan will also be mentioned in the same sentence.

Deflation is rare in the global economies of today. This is due primarily to central banks who around the world have engaged in a campaign to create a consistent inflationary environment for their own economies. This has worked for a few decades without hyper-inflation or persistent deflation in developed economies. Except for Japan.

Japan is one notable example of deflation which has taken hold in an economy and created a deflationary spiral. This is the essence of what economists fear. While this may sound scary, it isn’t, or doesn’t have to be. This week I will be discussing how deflation affects real estate, and why you should understand this if you want to protect your wealth.

What is deflation?

“Deflation is a fall in the general price level or a contraction of credit and available money(opposedto inflation).”

Deflation is generally characterized as a contraction of money and credit. This means there is less money in circulation, which generally makes holding it more valuable. Deflation is a market force that operates in the opposite direction as inflation.

While deflation generally refers to the amount of money and credit in circulation, it also references a fall in the general price level of goods and services.

While deflation tends to be chastised by many economists, it is a natural occurrence in a non-manipulated free-market economy. It is as important to a free-market economy as night following day. Prior to the creation of the Federal Reserve in 1913, both inflation and deflation were normal market forces that counterbalanced each other and made the economy an efficient allocator of capital. While there were good times and bad times, the free-market economy always self-corrected.

Deflation in of itself is not dangerous. What makes deflation dangerous and deserving of the prejudices of many economists is the use of leverage in an economy. In a leveraged, credit-based economy (such as most developed economies of today) it can be a very dangerous outcome.

Currently, the US has a credit-based economy which is highly leveraged. This is primarily due to the amount of debt and money creation which has taken place over the past 50+ years. Here is a chart of the creation of money since 1950 compared with the population growth over that same period of time.

Both of these numbers were indexed to 100 to compare the percentage change over that period of time. Does anything here seem out of place? The population grew 2x while the credit market grew at 142x.

Another way to look at the US economy is to look at the debt-to-GDP.

The US is one of 8 countries with a debt-to-GDP over 100%. The other countries with debt-to-GDP above 100% are Belgium, Greece, Ireland, Italy, Japan, Portugal, and Singapore. I don’t know about you, but I would rather be in better company. Interestingly enough, Russia has a debt-to-GDP of only 13%, Iran is 10%, and Saudi Arabia is 2%.

Debt-to-GDP is a good indicator of the leverage employed in an economy. A higher number means more leverage, and a lower number mean less leverage. Saudi Arabia has almost no leverage with a Debt-to-GDP of 2% while Japan has the most leverage with a debt-to-GDP of 227%. This may be one of the reasons Japan’s economy has been deflationary for over 25 years. Too much debt reduces the country’s ability to grow.

You can equate the Debt-to-GDP leverage in an economy to the leverage used to buy real estate via a mortgage.

If you understand how leverage works with real estate, then you will want to pay attention to the rest of this article.

How does deflation affect real estate?

In my prior post, These Top 7 Powerful Tools can Create Legacy Wealth from Real Estate, I discussed 7 advantages of why real estate is such a powerful asset class to create wealth.

A high degree of leverage can be used
Real estate is inflation proof
Creation of cash flow
Appreciation potential
Reduction of debt over time in real terms
A limited supply of land
Tax benefits

Five of these seven advantages are important when it comes to inflation or deflation because they are highly affected by it.

The hard truth that I hope to instill in you today is that if you use leverage with your real estate, you should keep a close eye on the deflationary forces in the US economy. To put it more bluntly, with zero inflation, the advantages of real estate would be limited to only the tax benefits and the limited supply of land. With negative inflation (deflation), your advantages of owning real estate with leverage would turn into disadvantages.

I want to be clear on this one point because it is important. Owning real estate in an environment with deflation is not a bad thing. It is only dangerous if you are using leverage via a mortgage. Leverage is the danger, not real estate itself. Don’t use leverage with a negative inflation rate(deflation). This would cause a negative compounding effect.

How does deflation affect your use of leverage when investing in real estate?

If you go out and buy a house and use a mortgage to do so, then you are employing leverage. Leverage is an important tool in the world of finance. It allows you to take a small amount of money and use it control an asset worth a larger amount.

For example, if you buy a $100,000 home, you can borrow up to 80% of the purchase price or $80,000 while only putting down $20,000. This is an example of someone using 5 times leverage, meaning that for every 1% the home appreciates, the homeowner’s equity goes up 5%. This works out well when home prices are going up. However, as most people know from 2008, that doesn’t always happen.

In 2008, the housing bubble burst causing home prices to drop, and in some areas, they dropped significantly. This put a lot of homeowners underwater, meaning that they had negative equity in their homes. If they sold their homes they would have had to come up with extra money at the closing. This happened in part due to the drop in home prices and partially due to homeowners putting down less than 20%. In some cases 0-5%.

Losing the equity in your home is easy to do when you use leverage. Leverage works both ways. While it might help increase your equity 5 times when home prices are rising, it

Deflation Increases Real Value Of Money