Question: Which investments have benefited the most over the past century as a result of low interest rates and increasing inflation?
Answer: Real Estate
After the end of the Great Depression (1929 – 1939), many investors created the bulk of their families’ generations of wealth by picking up real estate assets for a fraction of their values. Will history repeat itself any time soon?
Today, interest rates have fallen to near record low levels while inflation continues to increase rapidly. Rates and inflation are usually inverse to one another and are akin to being on a “see saw.” The lower interest rates fall, then the higher inflation rises (and vice versa).
The availability of mortgage capital is usually the most important factor in determining the “boom and bust cycles” of the U.S. housing market. People need money to get into and out of most real estate transactions, since most real estate buyers need third-party loans to acquire real estate.
During tight lending cycles like these past few years, both home sales and prices usually decline. When access to money eases up, home sales and prices can increase dramatically.
Recent underwriting requirements to qualify for mortgage loans have tightened significantly. Most residential mortgages (97%+) are now either backed or insured by some form of a governmental agency (i.e., FHA, VA, Fannie Mae, Freddie Mac, USDA Rural, etc.). As a result, the qualifying requirements are much more challenging for borrowers, so our financial leaders have tried to make mortgage loans much more affordable.
Cut Short Term Rates to Near Zero
From the mid 1970s through the early 1980s, the Federal Reserve was allegedly so concerned about inflation that they helped support a “Whip Inflation Now” (WIN) campaign, which even included buttons and bumper stickers. In order to try to quash inflation in the early 1980s, then Fed Chairman, Paul Volker, encouraged the raising of rates to as high as 21.5% for the U.S. Prime Rate in January of 1981.
The higher interest rates slowed down consumer spending and real estate purchases since the cost of mortgage loans had increased significantly as well. In practical terms, no one could afford a mortgage.
Not surprisingly, seller financed home sales options such as Contracts for Deed (or Land Contracts) and All Inclusive Deeds of Trust (AITDs) “wraparound” sales methods began to increase in popularity in the early 1980s, primarily because many home buyers could not qualify for 14% to 16% mortgage loans amortized for over thirty (30) years. As a result, seller financed wraparound loans, or new mortgages created for “free and clear” properties at 10% to 12% seemed relatively “cheap.”
Let’s compare today’s Prime Rate of 3.25%, the Federal Discount Rate of 0.75%, and the Fed Funds Rate of 0.25% with January 1981’s 21.5% Prime Rate levels. Today’s money is cheap.
In theory, the U.S. housing market should be selling at record levels with this cheap money out there today. However, the stagnant U.S. job market, rampant inflation (as partly noted by gasoline and food prices), and the more challenging lending underwriting guidelines have held back the next potential housing boom.
If lending does ease up, and the U.S. employment figures improve, we may all see much higher home sales and prices.
As Chubby Checker once sang, “Let’s do the Twist….” Operation Twist is an investment strategy created by the Federal Reserve in late 2011 and 2012 to allegedly help stimulate the U.S. economy. This program’s “Twist” nickname was coined to describe the Federal Reserve’s desire to purchase longer term U.S. Treasury Bonds while simultaneously selling a portion of the existing shorter term Treasuries at the same time.
The Fed’s theory was that by buying larger amounts of longer term Treasuries, then they may help drive Bond prices up, which would then drive the 10 year Treasury yields downward. Since 30-year fixed mortgage rates are tied to the 10-Year Treasury Yields, then lower 10-Year Treasuries leads to much lower fixed mortgage rates.
Quantitative Easing and Hyperinflation
What in the world is “Quantitative Easing” (QE) and why were there three rounds so far (QE1, QE2, and QE3)? In a nutshell, it is the attempt by the Fed to create more money out of thin air in order to invest in Treasuries, Stocks, and Mortgages to try to better stimulate the economy.
Each month, the Fed buys upwards of $85 billion dollars worth of Treasury Bonds and Mortgage Securities thanks to their QE policies.
How does anyone believe that the Dow’s 14,000+ levels recently confirm an economic boom now, when so many other segments of the U.S. economy are still stagnant? Most U.S. citizens do not own any stocks today, so they are not experiencing any of the financial benefits associated with the stock boom-time period.
As a comparison, the Dow Jones index was near a low of 940 in January 1981, when the Prime Rate was at 21.5%. Why risk money in the stock market back in the early 1980s when the bank savings rates were so high?
Today, the opposite is much truer. Why keep our money in banks to earn negative net returns (after taxes and inflation) when we may invest in stocks, real estate, or other assets that may be a better hedge against inflation? As such, the Fed is trying to encourage more investors into both the stock and real estate markets in order to stimulate the economy.
When inflation begins to accelerate, the buying power of the U.S. dollar falls. A weaker dollar leads to much higher prices for everyday items such as food, gas, utilities, clothing, and so on.
How can anyone today say that our inflation levels are relatively modest or low, when the cost of gasoline has absolutely skyrocketed in recent years?
It is not increased demand and lack of oil supply worldwide that is the primary reason for the rapid increase of gasoline here in America. Rather, it is a combination of a weaker Dollar, partly related to Quantitative Easing policies, and increased government taxes and fees that have led to $4 to $6+ per gallon nationwide in recent times.
Does Real Estate Have a Higher Potential Upside Than Stocks?
The Fed is trying to inflate our way out of this almost six (6) years of an economic slowdown with their “inflate or die” mindset by making mortgage loans so cheap that home prices eventually began appreciating significantly after borrowers could qualify for larger loan amounts and higher prices.
Just since last year, the median price of homes in regions like Las Vegas, Phoenix, and Los Angeles has increased between 5% and 20%+ so this financial strategy is beginning to work. The low rates, coupled with the declining home listing inventory, are making real estate a much more attractive investment option today.
The most assertive and knowledgeable real estate investors are trying to pick up the best discounted home deals for a fraction of their true market value today, and locking into near record low rates in order to better guarantee exceptional monthly cash flow for many years to come.
Real estate investment options, location, timing, and access to cheap money are all important factors in determining one’s future net worth and monthly cash flow upsides. But the key is to know how to find the best deals, and how to lock into the cheapest rates possible.
And so, is it time yet for history to repeat itself? Your comments are welcome.