Two all-beef patties, special sauce, lettuce, cheese, pickles, onions, on a sesame seed bun.
If you’re like me, you have childhood memories of your dad singing this on a long road trip as you pass by a McDonald’s on the side of the highway. This burger recipe/tongue twister, of course, is a jingle that is burned into my father’s memory from an iconic series of McDonald’s commercials in the ’70s. As stated by Mr. Jump in the original commercial, McDonald’s Big Mac. It’s more than just a hamburger. That’s right Mr. Jump. The Big Mac is more than just a hamburger. Nowadays, the Big Mac is also a major benchmark for the effects of inflation.
For those who are not familiar, the Big Mac Index is an economic index originally published in The Economist in September of 1986 to measure the purchasing power of global currencies against one another and also measure the purchasing power of currencies year-over-year. What started as a satirical metaphor for purchasing power discrepancies worldwide has now become a well-known and accepted measure of exchange rates and inflation over time.
While the Big Mac Index is not without faults, it is, in theory, a decent indicator of price discrepancies for a stable commodity that is pretty well understood (a cheeseburger), and, quite literally, everywhere. In theory, I can measure the difference in purchasing power parity (PPP) across the globe and over time by simply comparing the cost of a big mac at my local McDonald’s in 2022 compared to the cost of an identical recipe Big Mac in 2021. It will take into account the raw materials and the cost of labor and give me a decent indicator of inflation. And what is the difference in cost of a Big Mac from mid-2021 to now?
Average cost of a Big Mac (June 2021): $4.93
Average cost of a Big Mac (July 2022): $5.15
A whopper of an increase (fast food joke) of 4.5%. Ahhhh 4.5%! Better pull the money out of the mattress and buy up gold and Bitcoin ASAP or else your money is going to zero. But why? Why is everyone is freaking out about inflation? In previous years, you’d make a budget or look at your salary and go “Alright, I’ll increase this budget by 2% to account for inflation each year.” Why would we do that and why did people not freak out then? That is because inflation is a normal part of the human financial experience.
With the expansion of money supply over time and the increase in human population, things naturally get more expensive as time goes on. A wheat farmer sees the cost of water and seed go up over time so they start charging the flour mill more. The flour mill increases their price for the bun manufacturer who, in turn, passes that price onto Ronald McDonald, who passes it on to you when you order a Big Mac. You account for this increase in price when you look at your budget for the month and then go back to your employer to try and get a raise, who then has to account for higher wages in their financial model. And so on and so forth. Inflation cycles are fairly typical. What is atypical, is a rapid increase in the price of goods or services. That type of inflation, the one that is on every news channel right now, is what we need to talk about.
In order to do that, we must first understand what inflation really is and what causes it, the type of inflation we are dealing with, and how we can address this type of inflation. While we typically account for 2% inflation, we have also seen, on average, a 2% increase in Big Mac prices over the last ten years, excluding this past year. The difference between that normal 2% and the 4.5% increase we’ve seen this year is what the hullaballoo is all about.
Inflation is defined as “the increase in the prices of goods and services over time”. Like you are seeing in the news right now, inflation is the economic term for the increase in cost of buying goods and services last year versus now. For Americans, inflation decreases the purchasing power of the dollar. Money buys less when prices rise, raising the cost of living and lowering the standard of living for everyone over time.
These types of rapid inflation cycles are categorized into two causal types.
- Demand-Pull Inflation
- Cost-Push Inflation
On their own, these types of inflation and their causes lead to your standard 2% inflation. When they are out of control and combined with each other, more intense inflation will arise.
Demand-pull inflation is due to high demand for a product or service. When there’s a spike in demand for goods in the economy, prices go up and demand-pull inflation occurs. When unemployment rates are low and wages are increasing, consumers tend to spend more money and save less. An expanding economy directly impacts consumer spending, leading to a rising demand for products and services. The basic economic principle of supply and demand states that as demand increases, supply decreases, and higher prices are the result.
Three Contributors of Demand-Pull Inflation
- A Growing Economy. A strong and expanding economy usually means that people can get better jobs, make more money and thus spend more.
- Marketing and New Technology. Specialty products or asset classes from marketing and new technology can result in asset inflation. This type of inflation results in price increases across the board.
- Excess of Money Supply. The money supply increases through either expansionary fiscal policy or expansionary monetary policy. The money supply not only includes cash, but also debt such as credit, loans and mortgages. When the U.S. dollar decreases in value, relative to foreign currencies, the prices of imports goes up and thus prices in the total economy.
Does any (or all of this) sound familiar? In an average year, we’ve seen all three of these factors come into play. We’ve been in a period of unprecedented growth globally since the housing crisis. Rapid population growth, new technologies, and, in the past two years, excess of money supply. Regardless of your views on how the Fed has handled interest rates and how the government has handled pandemic risks, there is no doubt that we’ve seen all three of these factors take on an increasingly significant role in the past two years.
On the other side of the coin, cost-push inflation is caused by a lack of supply. When prices in production costs increase, like wages and raw materials, the result is cost-push inflation. During this type of inflation, the supply of goods decreases, while demand stays the same. The producer or seller then has the power to raise prices for consumers. For instance, if the cost of raw materials like oil increases, those added costs are passed on to the consumer to adjust to cost-push inflation.
Three Contributors of Cost-Push Inflation:
- Wage Inflation. The single biggest expense for businesses is usually wages paid to employees. When unemployment rates are low or labor markets are competitive, it forces businesses to increase wages in order to attract qualified candidates to hire.
- Currency Exchange Rates. When currency exchange rates are lowered, it triggers cost-push inflation on imports, making foreign goods more expensive than local or domestic goods.
- The Depletion of Natural Resources. Natural disasters and war may cause temporary cost-push inflation by destroying production facilities. If a tornado or an army tears through a large corn-producing area destroying supply, prices around the country will go up, while the demand remains high.
Again, call me crazy here but these all sound quite familiar at the moment. An increase in wages, decrease in purchasing power for many countries, and a global supply shock triggered by a natural disaster or, in this case, war have caused a rapid cost-push of inflation on the global economy.
Combine these six contributors with a rapid unleashing of pent up demand due to a pandemic, and here we are. This economic cocktail is causing havoc in the price of everything from gasoline to candy bars. But how do we measure the severity of inflation? There are technically many types of inflation but the four main types (or levels) are classified by speed, which are creeping, walking, galloping, and hyperinflation.
Creeping inflation is also known as mild inflation, this occurs when prices rise 3 percent a year or less. This causes consumers to expect prices to continue rising, which boosts demand for consumers to buy now instead of later when the product will likely be more expensive. This is the typical inflation we have seen in the past where burger prices increase predictably and no one panics, they just adjust their spreadsheet.
Walking inflation occurs when prices rise 3 to 10 percent a year. Walking inflation is bad for the economy because it ignites growth that is too fast. Consumers tend to stock up on products in order to avoid quickly rising prices, driving demand so high that supply can’t keep up. Wages can’t keep up either and ordinary goods and services are too expensive for the majority of consumers.
Galloping inflation is when inflation is 10 percent or higher. When this type of inflation happens the overall economy suffers greatly. The value of money drops so quickly that businesses and wages aren’t able to keep up with prices. Galloping inflation results in an unstable economy and foreign investors take their resources elsewhere.
Hyperinflation occurs when prices soar to 50 percent or more a month. This type of inflation is rare and has only happened in the U.S. once during the Civil War.
Based on the latest economics data of a 9.1% inflation rate, we are likely in the midst of walking inflation. Again, the Fed tries to keep inflation at around two percent annually to maintain a steady level of creeping inflation. With this high rate of inflation, wages are unable to keep up with the price of goods and services and start affecting everyone’s wallets. So what can the retail investor do about it?
The Case for Buying Real Estate
In times of high inflation, the best recommendation from experts is to invest in assets. Experts suggest commodities such as gold or equities such as stocks, but, a commonality in most experts’ recommendations, is to take advantage of rapidly changing prices and interest rates by investing in assets that are just as dynamic. Ladies and gentlemen, may I present to you, real estate.
Investing in real estate is one of the best hedges for inflation and, as detailed in previous blogs by Homebase, provides investment benefit even in times of simple creeping inflation. The three main reasons to invest in real estate as an inflation hedge are:
- Appreciating Price
- Steady Cash Flow
- Fixed Rate Leverage
Let’s dive into it.
One beautiful thing about owning a real estate asset is appreciation. Home appreciation occurs when the owner of a home is able to sell the home at a later time for more than they purchased it for. There is a relationship between inflation and real estate prices. According to Zillow, property values appreciate on average between 3 percent and 5 percent annually. In inflationary markets, appreciation rates are even higher, between 6 percent and 10 percent, varying by year.
To help drive home the power of appreciation, let’s say you buy a house for $100,000. With an annual appreciation rate of 5 percent, in only 10 years your property would be worth $150,000. In the last 10 years, the rate of inflation was about 19 percent. So, the house you bought 10 years ago for $100,000 would now cost $119,000 to buy. Your real estate investment has not only kept up with inflation, but far surpassed it with added value and growing appreciation. That’s because inflation impacts any sort of goods with restricted supply, and real estate, with the current state of homebuilding, lacks the increase in home supply to match demand.
Additionally, there are monetary and fiscal policies that affect the price of real estate. Actions to increase the money supply cause both inflation and home prices to rise, such as lowering taxes or increasing government spending. Reductions by the Fed in interest rates will also lead to an increase in real estate prices. When interest rates are low, people can borrow money relatively cheaply, causing an influx of buyers to enter the housing market. Home prices go up as demand rises and supply lags. This scenario would be considered a seller’s market versus a buyer’s market because home prices are higher with fewer options on the market. With real estate already an appreciating asset and steady decreases in interest rates pre-2022, investors have been flocking toward real estate markets to try and grab a piece of the pie and capitalize on home appreciation.
Steady Cash Flow
Another huge benefit to owning real estate long-term is the potential for ongoing cash flow from your asset. A smart buy-and-hold strategy will cover your monthly expenses and generate cash flow. To add to this, rent has a level of dynamism to it as property owners may also make annual rent increases in order to keep up with inflation and cover the cost of rising expenses. As rents increase, your rental property should produce enough money for expenses, plus cash flow that goes into your pocket year after year. Many long-term investors use this passive income to pay for their kids’ college, save for retirement, build real wealth, or buy additional rental properties (see The Longterm Benefits of Investing in Real Estate).
Many people love real estate because of the combination of both appreciation and cash flow. Great real estate investors do a ton of due diligence to buy homes in highly valued markets or markets in the “path of progress” to make major gains in the appreciation side, but also see that real estate addresses a need. That need is one inherent to the human experience in shelter, or a home to live in. By providing a service such as this, fairly priced real estate rentals are really a business with predictable cash flow due to the inherent need that is addressed.
Fixed Rate Leverage
Why not make debt work for you instead of against you? If you own real estate, that’s exactly what you’re doing. For many people, the idea of debt has a negative connotation. However, when tied with due diligence and strong cash flows, debt becomes leverage. Real estate is an asset that appreciates in value with cash flows that also adjust based on the inflation of rental prices. This makes the return on your asset investment go up while also making the cost of maintaining the loan negative — or cash-flow positive. If you had $400,000 saved up, you could enter into four 30-year fixed rate mortgages at a 75% LTV (loan-to-value), which allows you to buy four $400,000 homes instead of buying a single one in all cash.
In the meantime for the four homes that you purchased, let’s assume that all homes are cash flow positive, meaning the monthly rent that is collected is higher than the monthly payment on the mortgage. That would mean that, over time, the home would theoretically pay for itself. All while the money owed on your property is actually depreciating, thanks to inflation. Because inflation decreases the value of money, your monthly mortgage payment will be the same now (assuming a fixed-rate loan) as it is in 10, 20 and even 30 years. This type of calculated leverage in real estate is part of what makes investment in real estate a no-brainer for so many investors against inflation. Put together this leverage with an appreciating price of a home and rents that could go up every year due to inflation, it is no wonder real estate investments beat inflation nine times out of ten.
With an inflation hedge investment through real estate, there are so many benefits. Your portfolio can grow beyond the rate of inflation, you can diversify your holding out of equities such as stock and cryptocurrencies, and, maybe most importantly, you can maintain the buying power of your income. This allows you to invest for inflation rather than stockpiling cash away in your savings, helping to maintain your personal purchase power to take care of yourself and your loved ones, instead of having to cut back on your lifestyle. My question for you is: can you afford to buy real estate?
To be clear, our team thinks that the rental market is out of control. The price of rent seems to greatly outpace the wages and theoretical cost of living for many locales. It goes without saying though, that this problem exists because of the power afforded to owners and landlords that provide home rentals as a service for those who need it. To create a fairer real estate market, Homebase has new and innovative ideas on how to help more people become owners, specifically helping people own their first piece of real estate.
Real Estate at Your Fingertips
There’s no doubt that we are suffering from an increasingly greater divide between wages and what people can afford to own. The current rental market is only further exasperating that model and preventing most people from buying a home. Our system needs innovative solutions to solve one of the greatest problems of our generation. Our goal at Homebase is to democratize access to real estate investing. By doing so, we can help you combat the effects of inflation, a dollar at a time, and help everyone buy their Big Mac.
Thanks for reading.
Alex, Homebase Co-founder