- We look at what inflation throughout Canadas history and how to beat it
- Real estate as an input output business
- Disinflation, Deflation and more
Nick: Today’s episode is about how real estate only goes up
Dan: Well… it’s actually about how the buying power of a dollar only goes down
Nick: So I guess that’s it. We can finish today’s episode
Dan: Yep I hope you enjoyed it
Nick: But really, we’re going to talk about the reduction in buying power, which is also known as inflation and how real estate is considered a good hedge against inflation
We’re gonna start by talking about inflation, and then we’re gonna talk about inflation in Canada, and past inflationary periods and then we’re gonna talk about whether or not real estate is a good hedge against the current inflation environment and why it’s historically considered a good hedge against inflation
Dan: The reason I consider real estate be an inflation hedge is because it captures the cost of all of these goods. Compare real estate as an input and output business - like… making a car- you take steel, and labour, and technology, and make it into a car. With a house, you’re basically taking the cost of a bunch of inputs that are or can be inflationary and you’re baking them into a product… a house. And so a real estate investment includes land, which is a scarce asset that can be inflationary, but also includes lumber, siding and labor, and copper, and shingles, and
NICK: plumbing!
DAN: Exactly… plumbing too…
NICK: reminds me of that meme of plumbers in Toronto and it’s just a video of this guy eating a sandwich wiping his mouth with 20 dollar bills
DAN: dude you couldn’t have said it better… that’s exactly what I’m talking about. People are complaining about how much money plumbers make because plumbing is inflationary
And these inputs are all things that we know are right now in inflationary period, so owning a piece of real estate is owning the output of those inputs (which are inflationary) and therefore giving you a hedge against inflation, because you no longer have to buy them later down the road when they’re more expensive at the inflated by you get them today at their today value. The other reason is basically the idea of inflating debt away - far more sophisticated, and it has to do with inflation and the value of money against.
Nick: Ok let’s start with what’s happening with inflation - from the Statcan website
CPI
NICK:
The Consumer Price Index (CPI) rose 3.3% year over year in July, following a 2.8% increase in June. Acceleration in headline consumer inflation was mainly attributable to a base-year effect in gasoline prices, as a large monthly decline in July 2022 (-9.2%) is no longer impacting the 12-month movement. Excluding gasoline, the CPI rose 4.1%, edging up from 4.0% in June.
Electricity prices rose significantly in Alberta, increasing by 127.8% in July on a year-over-year basis. Excluding energy, the CPI decelerated to 4.2% after a 4.4% increase in June.
DAN:
The electricity price part is interesting to me because it impacts us as landlords - they go on to talk a lot about this on the statcan website:
“Electricity prices rose at a faster pace year over year in July 2023 (+11.7%) than in June (+5.8%). This acceleration was mostly due to a 127.8% increase in Albertan electricity prices, which can be volatile, amid high summer demand. In the early months of the year, when demand was last this high, provincial rebates and a price cap kept prices lower for consumers. These policy interventions were gradually phased out and ended in spring 2023. A base-year effect also contributed to the increase. When the provincial rebate program was introduced in July 2022, prices fell 24.4% month over month. This
Ding at 10 min mark
decrease is no longer impacting the 12-month movement, putting upward pressure on the year-over-year figure.”
NICK: Dan how bad are you patting yourself on the back right now for calling that base year effect
DAN: Honestly that actually happened faster than I anticipated. Base year effect hasn’t even set in yet. But generally I try not to pat myself on the back honestly…. I just try to find the next thing people don’t understand properly to shed some light on, because there’s too much misinformation out there.
NICK: and they say chivalry is dead
DAN: Moving on… The mortgage interest cost index (+30.6%) posted another record year-over-year gain and remained the largest contributor to headline inflation. The all-items excluding mortgage interest cost index rose 2.4% in July.
NICK: On a monthly basis, the CPI rose 0.6% in July, following a 0.1% gain in June, largely a result of higher monthly prices for travel tours, with July being a peak travel month. On a seasonally adjusted monthly basis, the CPI rose 0.5%.
DAN: Ok so inflation is going back up in Canada, as we predicted it would on this show, and my guess is that it’ll be going up again for a few more months until we end up a recession, then maybe we are stuck with deflation like China
NICK: have we talked about deflation before?
DAN: not really, we’ve just said it’s bad - you want to define it don’t you there… we haven’t had a Nicktionary in a while. Let me give you 2 here. What’s deflation?
NICK: Deflation. Definition: When the overall price level decreases so that inflation rate becomes negative, it is called deflation. It is the opposite of the often-encountered inflation. Description: A reduction in money supply or credit availability is the reason for deflation in most cases.
DAN: Not to be confused with Disinflation:
NICK: Disinflation is a temporary slowing of the pace of price inflation. The term is used to describe occasions when the inflation rate has reduced marginally over the short term. Unlike inflation and deflation, which refer to the direction of prices, disinflation refers to the rate of change in the rate of inflation.
So Dan, why is Deflation so bad?
DAN: you know, I’m going to use this to just dive right into the primary reasons why real estate is an inflation hedge… leverage
Read me this Tweet from Zerohedge
NICK: China CPI -0.3%, Exp.-0.4% China PPI -4.4%, Exp. -4.0% - We have deflation
DAN: If we see deflation in Canada, then the buying power of money goes UP, and the value of assets go DOWN, which means that if you have debt, you’re holding an asset that is worth less, but the debt is costing you more.
This is why deflation is especially bad for a place like Canada, where we have such high household debt… Top 5 in the world. Deflation would (probably will) really hurt us.
NICK: So for example you buy a house in 2022 at the peak for $1,000,000 and put a $800,000 mortgage on it. Then it DEFLATES in value to let’s say $800,000. Now you still owe $800,000, but the house is worth $800,000, so you lost equity in the house.
DAN: Right… now think about the opposite happening (and not just directly in terms of values going up, but also in regards to the costs of goods like lumber, plumbing, etc. before)
Nick, read to me from this article in May of 2020 - the headline is “Inflation is the way to pay off Coronavirus Debt”
NICK: Damn… shoutout to Noah Smith of Bloomberg News for absolutely nailing it
DAN: wait till you hear the article - his foresight gives me the shivers almost like reading chapter 6 of the 4th turning… and I’m sorry for those of you who this is a bit too in the weeds - but it’s an important thing to understand, given that we’re facing inflation right now.
NICK: Let’s just take a minute on this article because I think it explains a very sophisticated concept concept very clearly.
It says:
“Disrupt that delicate web and much economic activity can grind to a halt. This is probably why asset bubbles hurt the economy a lot more when they’re accompanied by high levels of debt. Coronavirus, of course, will be worse than any asset bubble.
DAN: The web of debt will hamper the U.S. economy’s recovery. Businesses that survive with diminished revenue will struggle for years to pay down debt before they’re able to start investing and expanding again. Debt will likewise hold companies back from changing their business models to better fit the demands of the post-pandemic economy. Workers burdened by debt will have a harder time switching jobs or going back to school, making the labor market less efficient at allocating talent to where it needs to go.
NICK: But there’s another way that the government can shrink the mountain of debt weighing down the U.S. economy: inflation. Because most interest payments are fixed in nominal terms, inflation makes existing debt less important in real terms. Raising the long-term inflation target from the current 2% to a still-modest 4% would substantially increase the rate at which debt effectively vanishes.
The U.S. has used inflation this way before. Economists Joshua Aizenman and Nancy Marion wrote:
DAN: The average inflation rate over this period [from 1946 to 1955] was 4.2%...inflation reduced the 1946 [federal] debt/GDP ratio by almost 40% within a decade.
A decade of 4% inflation today would do the same for total debt, not just government debt.
NICK: There are some difficulties and challenges inherent in this approach. First, inflating away debt is an act of redistribution from lenders to borrowers; creditors will oppose having their assets eroded. This anger might be blunted by reminding creditors that inflation also reduces the real value of the taxes they’ll have to pay to service government debt.
DAN: Second, hard-money advocates, including older economists who remember the high inflation of the 1970s, will fret that inflation could spiral out of control. This probably shouldn’t be a concern. The Fed has shown little difficulty in convincing the world that it’s committed to its 2% inflation target. As long as the Fed made it clear that 4% wouldn’t eventually become 6% or 8%, it would be able to hold the line at the new higher rate.
NICK: A third worry is that higher inflation could erode real wages. Theoretically, wages rise faster to keep pace with prices when inflation is high. But in the real world, this depends on worker bargaining power. And decades of weakened unions and rising industrial concentration have weakened worker power. The big overhang of unemployed workers in the coming depression will weaken it even further. The situation now is very different from the postwar period when strong unions and full employment made sure that wages kept pace.”
DAN: That last piece, you can really see happening in real time right now - this is why there’s so much civil unrest about inflation. This is why the political business cycle exists and we see constant swinging from politicians who create employment and inflation to politicians who fight inflation.
But there’s a more important piece there - a process which they describe as “inflating away debt”
NICK: so what exactly is that - inflating away the debt?
DAN: OK - let’s get into the weeds here quickly.
NICK: Dan if there is one thing I know about you, it’s that you do not EVER go into the weeds QUICKLY.
DAN: like that swimming scene from Harry Potter and the Goblet of Fire when he’s in the Triwizard tournament
NICK: dude what?
DAN: I dunno my kid loves watching harry potter movies
NICK: ok play it cool, good cover
DAN: what’s wrong with harry potter
NICK: not going there
DAN: yeah it’s a good way to lose half our audience
NICK: probably lose the other half if you support it though…
DAN: good point… let me make it clear WE ARE COMPLETELY NEUTRAL ON HARRY POTTER
NICK: on that note, let’s make it clear WE ARE COMPLETELY NEUTRAL ON BASICALLY EVERYTHING CONTROVERSIAL
DAN: Ok back to the weeds. To "inflate away debt" refers to a situation in which the value of money decreases over time due to inflation, leading to a reduction in the real value of debt. In other words, as the general price level in an economy rises, each unit of currency becomes less valuable, which means that the amount of debt denominated in that currency becomes relatively smaller in real terms.
This phenomenon can have important implications for borrowers and lenders:
Borrowers: Inflation can benefit borrowers because they are repaying their debt using money that is worth less than when they initially borrowed it. This effectively reduces the burden of the debt. For example, if someone borrows $100,000 at a fixed interest rate and inflation causes the value of money to decrease by 10%, the borrower effectively pays back a smaller amount in real terms.
Lenders: Lenders, on the other hand, may be negatively impacted by inflation. When they receive repayment, the money they get back is worth less than the money they lent out. This can erode the purchasing power of the interest income earned from lending.
Central banks and governments sometimes deliberately use inflation as a strategy to manage and reduce the real value of debt. This can be particularly beneficial for heavily indebted governments. By allowing moderate inflation to occur, they effectively reduce the real value of their debt obligations over time. However, this approach also has risks and consequences, such as potential loss of confidence in the currency and uncertainty in financial markets.
It's important to note that while inflation can help borrowers by reducing the real burden of debt, it can also have broader economic implications, affecting savings, investments, and overall economic stability. The extent to which inflation can "inflate away debt" depends on various factors, including the inflation rate, the interest rate on the debt, and the overall economic conditions.
NICK: so you’re saying if we’re in a period of inflation I should lever up and inflation will save me
DAN: absolutely not.
but let’s discuss the idea that rental income can hedge against inflation because that’s a little tough in canada right - depending where?
Nick - Rental Income
Rental Income: So rents are usually inflation sensitive - meaning they go up when inflation goes up. But in many places in Canada you can only increase rent to market value on turnover, which means when your tenant leaves and you rent it to a new tenant. Otherwise, you can increase existing rents by how much the government allows you to.
BC: Residential tenancies The 2023 rent increase limit is 2%.
In Alberta, there is no limit on how much a landlord can increase the rent but a landlord can only increase the rent after a year has passed from either the start of the tenancy or when the last rent increase was made.
Saskatchewan, no limits on rental increases
Manitoba - The 2024 rent increase guideline is three per cent, effective January 1, 2024. Tenants must be given proper written notice at least three months before a rent increase takes effect
Ontario Capping Rent Increases Below the Rate of Inflation Province holding rent increase guideline at 2.5 per cent in 2024
Quebec's housing tribunal released its rent increase recommendations for 2023 – with an increase of 2.3 per cent for leases that don't include heating. 2.8 per cent for electric heating, 4.5 for gas heating and 7.3 for systems that use heating oil.
Nova Scotia: The existing temporary rental increase cap of 2% will be extended to December 31, 2025. The Province intends to set the cap at five per cent per year starting January 1, 2024. That amount will be set in regulations.
DAN: so the government basically steals value by taking away your pricing power… Air BNB is the opposite of rent suppression as it gives the landlord the shortest term letting the landlord literally set his own market rate. The ultimate in pricing power. So running anti air-bnb laws is also real estate yield suppression and forces you into rent control.
Real estate offers investors a hedge against inflation through its pricing power. As inflation r increases rent also increases enabling landlords to offset higher expenses.
If you nerf the pricing power of real estate through rent control suppression you eliminate its ability to keep up with inflation.
This is okay for a while but if you do it for a long time or inflation is high it debases the intrinsic value of real estate by eliminating its pricing power.
Warren Buffet says the most important characteristic of a business in an inflationary environment is pricing power.
If you take a business and handicap it’s revenue growth while expanding its expenses aggressively you debase the intrinsic value of the business
So I actually think real estate is a good inflation hedge on construction costs (because a house bakes in all of those costs into a building), and it’s good in such that debt can be inflated away, but it’s not good in the most important part - pricing power, because our pricing power is regulated away in Canada.
It’s really kind of just an interest rate story to me - when rates are cheap, the prices of everything goes up, we see inflation and so does real estate values.
The bigger question is does real estate protect us against deflation like we’re seeing in China right now…
NICK - Summary
Real estate, which includes things like houses and apartments, can be a good way to protect your money when prices of things around you start rising, which we call inflation. Here are 5 reasons why real estate is like a shield against inflation:
Value Keeper: When prices go up, the value of real estate can also go up. This means that even if the cost of things is increasing, real estate once had those things as inputs - like lumber, construction materials, and labour, so the value of your real estate might grow too, helping you keep up with the higher costs.
Steady Rents: If you own real estate and rent it to others, you can earn money from rent. When prices rise, landlords can often charge more rent. So, you can earn more money as rents go up during inflation.
Stability: Real estate is considered stable and safe. Even when things in the world are uncertain, people still need places to live. So, real estate tends to keep its value better compared to other things that might change in price a lot.
Helps with Borrowing: If you want to buy something big but don't have all the money, you might borrow some. If prices rise (inflation), you might need to give back more money than you borrowed. But if you used your real estate as a promise to borrow money, it might be worth more too, which can help with the extra cost from inflation.
Limited Supply: We can't create new real estate very quickly. So, when more people want houses, the ones that already exist become more valuable. This can help protect you from rising prices during inflation.
Real estate can act like a shield that keeps your money safe when prices are going up. It's a smart way to make sure your money doesn't lose its value when everything around you is getting more expensive!