I recently received a comment from a post I wrote last month called “Real Estate in an Inflationary Environment”.  That post was in response to a different question.  Occasionally I’ll get a good question that I think others might find interesting, so I turn them into a post.  This is one of them.

The comment was as follows:

“I came across this (http://goo.gl/vBtxt) website while doing some real estate research online. The case is made that the real threat we face is deflation rather than inflation because the vast majority of money in circulation is actually credit which cannot possibly be paid back in full by everyone. So if I understand it at all, the claim is that eventually a great deal of this “money” will implode as people foreclose, default, etc. This makes sense to me. 

It would seem that it would take enormous amounts of monetary inflation just to offset that, which is what the intent it now I would assume. 

If this thesis holds any water that would make buying a home right now quite risky. I always appreciate your take on this topic, so I’m curious what you think about this view. Is there anything to this? How does this threat factor into buying a home now? I am considering buying a second home as a single family and moving out of the duplex I own and occupy now, and renting both units out. 

Thanks.“

Someone who expects deflation in the short run is taking a different view from what I have.  I am not saying that person is wrong.  It is just that I give a higher probability to inflation in the near future, given the analysis I have done.

One area that I often disagree with deflationists is the inevitability of it.  The comment above says that “the vast majority of money in circulation is actually credit which cannot possibly be paid back in full by everyone.”  I think it is playing technical word games to say that most of the money in circulation is credit.  If this were the case, why has there been virtually no deflation for the last 70 years?

Again, I’m not saying a deflationary situation is impossible or won’t happen.  I just believe that we will see much higher price inflation before we see anything resembling a serious deflation.

There is one thing that Ben Bernanke understands.  He said in a speech back in 2002 the following:

“But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.“

The Fed can always prevent deflation.

The problem for the Fed is if it hits recession/ depression conditions at the same time as high price inflation.  We saw that back in the late 1970’s and the Fed was forced to save the dollar and bring on a deep recession.  While this could certainly happen again, we haven’t hit high price inflation yet, so I would expect the Fed to keep creating new money out of thin air until it is forced to stop by high price inflation.

So how does all of this fit into real estate?

I recommend buying investment property that you can rent out.  It is best to buy something where you have positive cash flow.  If you don’t have to sell it, then deflation does not matter to you in the short run as far as housing prices go.  Your only worry is about the rent.  But if you have positive cash flow, then it gives you a little bit of a cushion for lower rents.  The good thing is, your costs should also be lower with deflationary conditions.  Taxes should be lower and maintenance costs should be lower.  The one thing that won’t go down is your fixed rate loan, or at least until you pay it off.

I am not one of these people who advocates that you leverage everything you can.  While I am not against taking out a mortgage, I am also not against paying off your loans.  If you buy and hold a property for long enough, you will eventually pay off your loan (or hopefully your renter will), assuming you don’t refinance to longer terms.  I actually think this should be the ultimate goal of every real estate investor.  Once your loan is paid off, then your cash flow will increase dramatically.

If you are concerned about deflation and you still want to invest in real estate, then paying off your mortgage should be your primary goal.  If you have a mortgage rate of 4%, then every extra penny you put into your principal balance is the equivalent of a 4% return on your money.  This is a hedge against deflation.

In conclusion, I don’t think a major deflation is likely, at least not in the next several years.  But even if you disagree with me and think deflation is likely, it doesn’t automatically mean that you shouldn’t look at real estate investing.  It just means that you should try more aggressively to pay down your mortgage before the deflation hits.