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Why Deflation Will Hurt The Real Estate Investor
To an academic, deflation would mean a decrease in the general price level of goods and services. Even though that sentence is easy enough for most people to understand, there can be quote a few interpretations of what is deflation. It can be a decrease in the overall money supply in the financial system. An increase in the value of the dollar that allows it to purchase more stuff. Or just simply, things are getting cheaper to buy.
But for a real estate investor, the less expensive lifestyle is just a benefit on the surface. Deflation can actually be catastrophic to investors. The reason why that is so is due to how our monetary systems are dependent on debt and money supply. An individual might feel that deflation is not something that affects him specifically. But because it is something that affects the whole economy as a whole, everyone will be affected.
Please take a seat as the information here can be intense.
When the growth rate of debt consistently outpaces the repayment of debt, the total amount of money in use circulating in the economy starts to decrease. As the total amount of money shrinks like a deflating balloon, there is less money available to spend while the amount of goods and services remain the same. The prices of goods and services then start to drop. In another way, you can see it as your dollar being able to buy more stuff.
Initially the general public will be cheering at the lower cost of living. But the positive vibes will soon dissipate as the implications start to kick in. Don’t get me wrong. It is great to be able to buy more stuff with less money. But this is only good if all your money is in cash with little to no debt. For simplicity sake, let’s just say that prices of goods and services fall by a flat 10%. This is equivalent to getting a 10% increment on your salary even though your salary remains the same. That’s a delicious thought isn’t it?
So what is the problem?
The problem arises when we have an economy driven by debt. Just ask yourself a question. Is the cash you have, more than the debt you owe in dollar terms? Because the amount of debt in the system hugely overpowers the amount of money, most of us will have no problems keeping up with our debt obligations as long as the money supply is expanding.
However when money supply, or debt, starts decreasing, money becomes more difficult to earn. If you are on a fixed repayment plan for a loan, you will still be required to pay the fixed amount each month. And since the value of money is higher in deflation, you are theoretically paying more for your loans than you have been before. So while you are now able to buy more with the money you have, you are also paying more towards repaying your loans.
As money becomes harder to earn due to it’s scarcity, more and more people will be contented to keep their cash with themselves instead of spending it to feed the economy. This shortage of money supply slowly compounds and organisations will start to find it tougher and tougher to profit. Job cuts or “restructuring” start to commence, business operations start to scale down, and even expanding businesses will find it hard to find affordable money to fund their expansions.
To make this point clear, let’s just assume for a moment that everything come to a standstill. If that is the case, the amount of money in the system has to be much less than the amount of debt in the system. This is because debt makes up of principle and interest. And it also includes debt that has been recycled into new debt without real money being created. We haven’t even talked about commercial bank money (chequebook money).When money supply and debt stops increasing or decreasing, it would be obviously clear to the observer that there is not enough money in the system to repay the debt being owed. At this point, defaults are inevitable. To keep itself afloat, the system has to issue more debt or create more money so that borrowers are able to repay the outstanding loans. But as we know from the discussion so far, money supply is shrinking while businesses and individuals are unable to borrow more either because it is too expensive or there is no certainty on the ability to repay.
The result is that we will start to see more foreclosures as investors are unable to generate enough income to meet mortgage payments while deflation has also made it more expensive for their debts to be repaid, more people will find themselves with little choice but to file for bankruptcy as it is that much more convenient than to take on the money crisis head-on, and in extreme circumstances, banks might start to tumble from the lack of cash even after taking over loan-defaulted assets as there is no money available for buyers to buy them.
As businesses start to have less confidence in themselves to repay credit, they also stop borrowing or stop using their credit facilities. With no funding for growth, a business will be doing great just to be able to maintain their productivity levels. This is the same with individuals. Now that the pool of borrowers get smaller and smaller, the mismatch between total debt and money in the economy starts to get bigger and bigger.
The inevitable is that there will be lesser jobs available, wages start to fall. Revenue drops as people are too scared to spend their money, resulting in plummeting prices. With a desperation to generate operating cash flow or just simple working capital, businesses start to decrease prices even more.
The shrinking value of loan collateral puts lenders into a panic. They start recalling loans or ask for principle “top-ups” on those they have a legal right to do so. But the borrowers cannot find the money to pay them as there is simply no money available to be made.
Should such a downward spiralling event take place as the script insists in theory, the only way to get out of it is to rely on the government. The government will have to pump money into the system by either spending more money or by creating more debt. This is why government expenditure is so important to a healthy economy. You can also see now why in certain nations, governments are relentlessly pumping money in the form of debt into the system. It is to prevent huge financial catastrophes from occurring. The only way to sustain the financial system is to maintain inflation at a rate that will not cause riots sprouting up in the streets.
If you are a real estate investor, there are a few ways that deflation will affect you.
1) Properties become cheaper for you to acquire as your cash is worth more while properties devalue.
2) Mortgage or loan repayments become tougher to fulfil as it become more expensive to repay fixed payments and money is harder to obtain.
3) Your existing properties will look more appealing to prospective buyers who have cash as their cash is worth more while your houses are worth less.
4) If you consistently fail to meet your mortgage obligations, you could be staring at foreclosure right in the face.
5) You will find it all the more difficult to obtain a loan to complete a purchase transaction.
6) The rising cost of operating a business due to the rising cost of money may require you to totally restructure your business operations just to stay afloat.
7) Cash becomes king. But do you have the courage to spend it knowing that you might have to work twice as hard to make the same amount?
Even if you have all the resources to be self-sustainable and have full confidence to ride the tide during times of crisis, the resulting fate of the economy due to deflation will not do your real estate investments any good at all. You want a booming market so that your properties appreciate in value and rentals rise. I guess that is the world most investors would like to live and operate in.