The IDEAL Investor Show: The Path to Early Retirement

Ep 87 High Inflation...again

• Axel Meierhoefer • Season 2 • Episode 10

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Hello, and welcome to another episode of the The IDEAL Investor Show season to focus on cash flow. And today, we want to talk about and dive a little bit deeper into high interest rates, what has happened in the last kind of like 18 months or so. And what is really the impact on the one hand to our daily life to the economy as a whole. And to us as investors, what do I believe you should be aware of and think about and know about when it comes to higher interest rates. So just to tap in real quick into how did we actually get to these much, much higher interest rates that we're seeing today all across the board than what we had that say during the pandemic in like 2020, or even still in 2021. So in your memory, that when the COVID pandemic came into existence, initially, the reaction was, let's shut everything down, try to keep everybody safe. And because we needed to find a way to still consume and people were impacted, the government decided, let's give everybody money. And that wasn't just in the United States and other countries, they did the same thing. The amounts were different, but the government basically gave out money. Now when I say gave out money, it also means the government printed money, where there wasn't really a means of exchange, right? Normally, when money is created, there should be something in return. But in this case, and this is mainly possible by either generating new debt with the US government generated way more debt, but this money that was printed and became an is now part of the national debt was given out to people without anybody having to do anything for work for it or anything like that. Now, what happens if you put a lot of money into the system, and if you look at during the pandemic time, basically, between the beginning of 2020, and the middle, about of 2022, in those two and a half years, 25%, one quarter of all the dollars that were ever created, have been created in this short period of time. Just think about that for a quarter of our dollars ever in existence in two and a half years. Now, what happens if you flood the system with money? And on top of that, think about it when you flood the system with money, and people can go anywhere, what do they do they start buying stuff? And what is the typical way? How people as companies, as owners of companies determine the prices for their stuff that they want to sit, they look at, what can I sell it for? To have a certain amount of demand? It's also called the addressable market. Who are all the people in the marketplace who might be interested in my product in how much are they willing to pay? Well, when there are millions upon millions of people who want to purchase, especially because they got free money, any good business person would say, Okay, well, I used to sell this item for $100. But I can barely meet demand. Well, I might as well see if I can sell it for $120. And if there's still a demand, you might try to see if you can sell it for under $30, and $140, and so forth. Now we are focusing on real estate and one of those areas where this actually happened because people had suddenly money that they didn't need to work for, which allowed them to make down payments on houses. One of the areas where prices completely went crazy was real estate, residential real estate. And you will probably remember that story is where people lined up 2030 4050 People with masks on to go and look at a house and beat each other up to a higher and higher price just to be able to purchase the house. Now there might have been also a certain part of it to say people don't want to live in an apartment complex with it pandemic stuffed into a little apartment, they would like to have their own house, but part of it is also where do I take the money to actually make the downpayment. And when you get free money, it's more likely but it was true for many, many, many other things in the economy. And what did that trigger companies just tried to find out where's the price where I can sell everything I make? And that price was significantly higher than what it used to be in 2019. Before the pandemic, what did that do it generated inflation and the Federal Reserve was supposed to basically be in check of how much money is being put into the system and how much does money cost and the cost of money is basically interest. They were supposed to look at this and in the middle of 2021 when everybody said hey guys, are you aware you can be Think this much money into the system, you generating inflation with all this money because people want to spend it, they're frustrated sitting at home. So they at least want to buy gadgets or they want to sign up for like Netflix and Hulu and Apple, TV and five other things, you know, because they have all day long to binge watch stuff, which they did, right? It didn't matter whether it cost them 100 or $200 a month, they got the money for free from the government. So the Federal Reserve at the time said, we don't think this is real inflation. This is just because of the pandemic, and it's gonna go away. Well, here we are now in 2023. We all know it didn't go away the latest numbers we have, is there still 6.5% or so inflation? At the latest numbers? It was way higher than that, as you remember, but 2% is what the Federal Reserve was. So what did they do? They started increasing interest rates, meaning how much does a bank need to pay the Treasury or the Federal Reserve to take money that printed money, and then give it out in the form of money from credit cards in the form of money for car loans in the form of mortgages in the form of lines of credit to businesses, and so forth, and so forth. So that's what this interest rate is. And if you really want to kind of get a taste of what this change has meant, the top interest rate that we're sitting at right now is 5%. At the time, when the pandemic started, the average was between zero and 0.5, half a percent. So that is basically 10 times more, right? If you have half a percent, now you have 5%, it's 10 times more, it's not just four and a half percent more, it's 10 times more. And what does that mean 10 times more, if you had to pay$1,000 A month as a business, because you had loans, and the interest payment was $1,000, because it was half a percent. And now it's 10 times more, you have to pay instead of $1,000, you have to pay $10,000 a month just on interest. And that means those $9,000 of difference have to be generated in your business as profits. So you have a chance to pay for that. That's really the impact. Now there are lead and lag times and the big problem is when the Federal Reserve or the government increases interest rates from half a percent to 5% 10 times more, it's not an instantaneous impact. Why? Because if you it's the same thing like with us in our investments in mortgages, when we buy a house in 2019 was a 3% mortgage for 30 years, it doesn't change only now when we buy a house in 2023. And the mortgage, I mean, the Fed rate is 5% mortgage is seven and a half or 8%. Now we would have to pay the 8% on the same 30 year mortgage, the other house still goes at the same thing. And this is true for lines of credit and other things with companies as well. If a company has a five year loan at 0.5%, or 1%, only after that five year period is when they need to renegotiate the another loan or the following loan. Now the impact of those interest rate increases actually hits. So that's part of the reason why even though you hear in the news and heard in the news that interest rates have gotten higher, it hasn't hit the economy directly yet in full force. But where has it hit? It has hit for example, really, really massively in credit cards, right? The credit card interest has gone up massively. And especially in the United States, there are many, many people who are in debt with credit cards to a large extent. Now the next thing where is this connected is inflation. I said earlier, right now it's 36 and a half percent. That means if you still have the same income, which is very likely or very close to what it was a year or two ago, but everything else has gotten really much more expensive. How do you pay for it, and a lot of people if they have exhausted their savings, they put these charges onto the credit card, even though credit card interest rates have gone to 1819 20 and above interest rate. So credit cards is one area where it is right away. The other area where it's much quicker is for anybody who wants to get a new car and needs to finance it, which is the vast majority of people, your rate that you have to pay for a loan on a car has gone up significantly. And that happens more often than for example, investing in a house. So what does this mean these higher interest rates, like I said, the banks and anybody who has a relationship with the government pays now around 5% for any money that they get from the government, when they give it out as a mortgage. It's between seven and a half and 8%. When they give it out for credit cards. It can be up to 20% when they give it out for a car loan. It's probably also about eight to 10%. Right. So those are the different areas where we as consumers really fear these increases in interest rates for our investments in residential real estate and for our age. which is the aim for season two that we're in to look at? How do interest rates impact our investments in residential real estate, one of the things that has gotten even more important is the performance of the property. And you know this from all the kinds of materials and podcast episodes and I was on. So guess what any kind of writing that I've ever done, I've always said, the price of the house is really just one number, what's much, much, much more important is the performance of the deal. And what we've always said in the past is we don't want to invest in an existing property that doesn't at least generate$200 of positive cash flow. That's the performance $200, how do we get there, let's say we have $120,000 house can we can rent it out for $1,200. And then we pay our property management, they get $120, we pay insurance, that is another, let's say,$130. So the total is 250, then we have our mortgage on it. And let's say that's another 550. So we have 800. Now that we need to pay taxes, that's another 100. So we're at 900. And when we look at that we would have from 900 to 1200 $300, positive cash flow, and that would be good performance. That was how we looked at the years, let's say up to the end of 2021. Now we have these higher interest rates, and what happens which variable is actually increasing the most. And that is the mortgage, I just said in this example, let's say the mortgage payment was $550, when the interest that we weren't able to get for a mortgage at the time was about 4%. Now it's 8%. So our mortgage is no longer 550, it's probably more in the area of 700. That's $150 more just because of the higher interest. And when we made $300. Now we only make $150. And the question then becomes is $150 When our goal is to at least make $200 of positive cash flow after going through this sort of calculation, low asset performance to say we make the deal or we don't make the deal. That is really one of the things we want to look at how high is our cash flow? Now, I want to point out something and a lot of people are not necessarily aware of that. And I'm saying this mainly for our international audience. But I also want to have our domestic audience to be aware of it almost everywhere in the world, when you actually sign up for a mortgage, the mortgage can be 20 3040 years long, even but the agreement with the bank on the financing terms, there's typically no longer than 10 years and certain countries, it's very common to only be five years or seven years. What does that mean? If you got a property, let's say in 2018, and you said, Okay, I got the property, I pay 3% interest, and my duration is seven years in 2025, you have to sit down after seven years, you have to sit down again with the bank and say, Okay, for the next seven years, or for the next 10 years, what are the terms and in some cases, like I said, it's five years, seven years, up to 10 years maximum 10 years is the maximum, we are in the US in the very, very unusual situation, that we can get the mortgage term fixed for 30 years with an agreement for 30 years to have that fixed interest rate or the fixed terms. So for any investment that any of us did before, kind of like the end of 2021 and be locked in purpose and interests for 30 years, you would never want to touch that. There's also no reason whatsoever to ever pay this off faster than you absolutely have to with these 30 years. But here comes the answer to the question. If we now know instead of getting the $200 we aim for for all of our investments, we can only get $150 mainly because of the increase in interest rate, this fact that you can lock it in for the whole term for the whole 30 years can become an advantage to say, well, maybe it can become a good deal, because it is very likely that we will not forever have interest rates of 8% or 7% or 9%. And what you are allowed to do in the US at any time, within your 30 years, you can pay off that mortgage and get a new one, which is called refinancing. So you can sit down and see okay, how low do interest rates have to go from here to make those$50 Extra they don't have to go back all the way to 4%. But if they come down from let's say seven and a half percent to five and a half percent and you were to refinance, you were now back at you $20 or even more. So that's something that the impact of higher interest rates needs to be considered. And a lot of people ask me, okay, I understand this that you might not be You're performing as well. But if I'm very aware that the only reason why it doesn't perform is the interest rates, and I'm agreeing with AXA, that interest rates will not be able to stay at this elevated level that they are right now, then it might still be a good deal. Now there's one other aspect that I wanted to point out. And that is, you have to keep in mind up and like I said, up until the middle or end of 2021, there was a huge amount of competition between everybody who was interested in residential real estate, especially in single family homes, because it wasn't just us as investors. But because the interest rates were so low at the time, and people got free money from the government, they were also interested to move up, as they said, from apartments or living at home into single family houses. That was a huge amount of competition now that interest rates for mortgages are in the area of about 6%, or five and a half 6%, something like that, if you are moving into a house, you said and about 8% or so if you do this as an investment. And a lot of the people who would still like to live in a house and buy a house for themselves, they just don't qualify anymore. And it's not just purely the interest rate. But just like I said before, if our mortgage for our $120,000 house was 550 a month, and it is now 700 A month purely because of interest rate. That is also true for anybody who wants to get a mortgage, to move into a house own the house and move into it. And the question is have you actually made so much more money that you can afford this increase in monthly pay, that's called qualifying. And lots and lots and lots of people don't qualify for mortgages anymore, because their wages are pretty similar in the last few years, they haven't really increased by much more than three or 4%. But interest rates have gone up tenfold. So because of that the banks look at the numbers and say, Hey, sorry, for the amount of money that you would have to pay per month, you just don't make enough, you don't qualify for us, that takes a huge number of competitors, other people who would want to buy the same house that we are interested in off the market. And that means we have access to more deeds that are kind of close to performing the way we want them to perform. And there's one particular area in this context of high interest rates, I want to point out that you can also see in the news, and you can track along you can Google it and so forth is the difference between somebody who wants to offer input on the market, how's that already exists, either it's been renovated, or just a regular house that somebody wants to sell, and something that is new construction. And the issue with that is in new constructions. And regardless where you live in the country, if you identify a certain area where you want to build one or multiple houses or a new neighborhood or something like that, from the day when you say okay, I want to purchase this and build this neighborhood until it's finished. And you can actually sell it, you easily look at two years, three years time. So that means all these different neighborhoods are different areas where new residences, new single family houses, duplexes, stuff like that. And now finishing, they probably started somewhere in 2019, at least the planning and the permitting and stuff like that started in 2019. And I'm saying this, because with the pandemic, that was basically almost a year where almost nothing moved forward, because everything was closed, right. So those two years became typically three years or three and a half years. So a lot of the new build stuff that is finishing right now is finishing based on intentions and the assumption the market would be and the interest rates would be what they were in 2019 and 2020. Now we have a totally different scenario where as I mentioned earlier, people don't qualify anymore. And those are the people for which these new construction projects were actually created. That's a benefit to us as investors because these visitors cannot sit on these properties very long. So the only thing that they can do is offer these properties with better deals. And there are two ways that they can offer better deals, they can either lower the price, which means we have a lower mortgage, which means when we put tenants into these properties, it can become a performing deal or very close to our $200 Plus, or the other thing they can do is to say okay, I don't want to lower the price, but I am willing to prepay a bunch of the interest that you have to pay just because interest rates are so high right now. Right? So if you think about it, if you had an 8% interest on $100,000 mortgage, that $8,000 a year and there are builders out there who say I give you $16,000 that you can give to your mortgage companies as prepaid mortgage so that you only have to pay the principal, I pay the mortgage, but you give me the full price of the house. And the third option is that the builder says I'm coming down with the price and I'm willing to pay Some of the interests for you. So you take this house off my hands, because one house might be possible. But if you're a builder, the only way you stay in business is by keep building houses. And you can only afford to keep building houses when you get money for the ones that you already finished. So that's another benefit. And I want to encourage all of you who are actually thinking in purchasing something with the performance aspect, and I'm always preaching in mind. And in light of these higher interest rates, to look out in the areas that you are interested in to see if there are any new construction projects, we have builders actually offering these kinds of deals, and you always have to keep in mind, they also still need to rent properly, right? Like your rent has to be on a new construction, still about point 8.85 of the purchase price, which means if you were to buy a new place for $200,000, you need to be able to get about 16 $1,700 in rent, if that rent is not possible in that area is still is not a good deal. But if you can get that rent and some concessions from the builder, you might be able to get a brand new house for a fair price that becomes an asset. And the same applies just like regular existing out in three, maybe four years. That's my prediction three to four years until interest rates will be back down to where they are more amenable to us, you will refi the auto mortgage and get down to the lower interest rates into much much better enhance environment. There is actually a book that I've basically suggested for many, many times, it's really a business book. But the title fits here really well the title is good to great. And in this case, if you find any of those deals where you can either move in because the competition of regular buyers is gone away, or a builder wants to get rid of a house, but they know that high interest rates make it hard for regular people, it is maybe a good deal right now, even though you're only making $150 positive cash flow right now. But as soon as you can refi, then it becomes a great deal. So it goes from good to great. What I still would not advise for you to accept, if you look at any investment in residential real estate is a break even deal. If you calculate everything in either the BiggerPockets calculator or DHS or any of those calculators and you find out it just barely covers right like you get $1,200 in rental income. And when you add everything together, there is zero left, that's break even, that's not acceptable. Because there are too many variables that can go wrong. If you can't make at least 100 150, or somewhere close to $200 Stay away and look for another year that performs a little better. So yes, we can maybe compromise a little bit on going down on our minimum of $200 or more, but don't go all the way to zero. So again, high interest rates have a huge impact on the economy. And the last thing I want to mention that you also want to be aware of when you consider an investment in residential real estate. And that is your tenant when you do the economic analysis, or you ask us to help you with the economic analysis of the area where the property is that you want to buy. And as the Federal Reserve keeps increasing interest rate as car loans, credit card loans, all that kind of stuff gets higher and higher and interest rates higher and higher in costs for regular people don't forget these regular people are your tenants, right? And I wrote down here what is in my opinion, the probability or priority that tenants will have when it comes to what do we need to actually pay for first, I believe when a tenant like a family with one or two kids lives in one of your single family residences, the first thing they want to pay for out of the money that they make is food, I believe number two after food is housing. And housing includes things like you know, insurance and that kind of stuff. Then the third thing that I believe most people still are very dependent on and will probably tried to pay for the car, especially when they need the car to get to work. And after that come things like credit cards and other loans and things like that. The issue with that is when credit card debt gets too high, and you can't get any more money out of the credit card, then the next thing they say is okay, I can't pay the credit card anymore, then the next thing is okay, well, my income hasn't increased high enough, I can't pay my car loan anymore, then the car gets taken away from the company like General Motors or Ford or wherever the cars from they literally take the car if you don't pay for the loan relatively quickly within three or four months at the latest. And so now they don't have a car anymore, which can mean they can go to their job anymore, which then means for you they can't pay the rent anymore because they don't make money anymore. So you want to invest in areas where the deal the performance of the deal is good like we discussed earlier even in this high interest rate environment, but you also want to pay even closer attention to what is the income and the likelihood that the tenants can consistently do the work make the income and pay for the rent. It's not the highest risk, because credit cards and car loans I believe, at higher risk and student loans and stuff like that. But there is a point where tenants will have to say, Well, I have to feed my family and I can't pay the rent anymore. So that's an important consideration as well, overall, what do I think is going to happen with these high interest rates? And where are they going to go? I think we have seen a bunch of hesitation already from the Federal Reserve, the last time that they increase, they only increased by a quarter point. But there is a last thing I want to have you realize when it comes to high interest rates, when you have like we have right now six plus percent inflation. And any economist any book, any course that you take that discusses how does a government get inflation under control, then you find that they say the one thing that needs to be accomplished in almost all cases is that the interest rate in the marketplace needs to be at or above inflation, which means when we have stood to this day six, or six and a half percent inflation, our interest rate is five, we have taken steps towards solving the issue, but not all the way. Now I believe the hope that the Federal Reserve has is that inflation is coming down to five and a half and then five, and maybe four and a half. So even if they don't increase interest rates much anymore, or at all anymore, maybe they go to 5.25, or something like that, that inflation will come down so that by that coming down of inflation, they will ultimately have interest rates slightly above inflation. What that means is yes, they might stop increasing, but they will have to keep the interest rate relatively high and a little bit above inflation for a while to actually have an impact. Because so far, even though they started at the end of 2021. So they're basically at it for more than a year. Now, they have not reached the point where the interest rate between banks and government and businesses is above inflation. And only when they reach that point, and then keep it there for a while, will they really generate the impact that they're looking for. So I think people need to be very careful. And this is why I'm saying from here, I think it's still another three years until we back down to something that really makes it worthwhile refinancing. But until then, we still keep our principles, we still look for performance, we still want to make sure that we are investing in areas where it's economically viable, where our tenants are able to afford the rent to pay us consistently and not constantly turn over. And now that you have a better idea of the impact of the high interest rates, there are negative things, especially super high rates on car loans and credit cards. But they are really benefits to us if we're willing to sacrifice a little bit on our positive cash flow because the competition is much lower. And especially in the new bed market, we have an opportunity to get some better deals than we had in the last 10 years because these builders just have to somehow sell the properties that they build. So I hope this was educational gave you a little bit of an insight and illuminated this whole issue of high interest rates until the next show be well stay safe. Thanks for listening. And I hope you enjoyed today's episode of The IDEAL Investor Show more info and the links we mentioned during the show in the show notes or you can go to our website at IDEO redcross.com and sign up for the Apple podcast link. And if you'd like to talk to me sign up for strategy call. Hopefully you want to share what you learned with your network and bring more people in we are really eager to hear your comments and until next time, be well stay safe and ciao.