Why deflation hurts a real estate investor


Deflation is something many economists have made out to be an economic bogeyman, saying that it could be the worst possible outcome in any economy.

Economists and investors would be rightly afraid, given the experience of Japan which is usually mentioned when deflation comes up.

However, deflation is rare in the economies of today. This is largely due to the policies of central banks that have engaged in a campaign to create a consistent inflationary environment for their own economies.

Japan is one example where deflation has had a severely negative impact. While it may sound scary, it isn’t or doesn’t have to be, despite the fears that most economist have about it.

This post will cover the impact of deflation on real estate, and is meant to be a primer on how to think about its impact on property investments.

What is deflation?

Deflation is a fall in the general price level or a contraction of credit and available money (opposed to inflation)

This means there is less money in circulation, which generally makes holding it more valuable. It is a market force that operates in the opposite direction as inflation.

Some people understand deflation as a fall in the general price level of goods and services, and it can also be understood that way.

Deflation in and of itself is not dangerous. What makes it dangerous is the use of leverage in an economy experiencing deflation.

Many developed economies today such as the US, UK, Japan, Hong Kong use leverage for real estate and infrastructure financing, so it’s unavoidable in today’s world.

Let’s take the US as an example. The economy today is highly leveraged.

This is due to the amount of debt and money creation that has taken place over the last 50+ years.

Look at the chart below which indexes to 100 in 1950, the amount of credit compared with population growth.

Population and credit growth
Population and credit growth

What stands out? Population grew 2x while the credit market grew at 142x.

Central government debt-to-GDP is a good indicator of the leverage used in an economy. A higher number means more leverage, while a lower number means less.

Central government debt
Central government debt

How does deflation affect the use of leverage in real estate investments?

Since deflation is defined as a general decrease in the price level of goods and services, when you buy a house in a deflationary environment there may be a chance that there will be negative equity in your home.

An example of leverage is if you buy a S$1m home and borrow up to 80% or S$800,000 while only putting down S$200,000. This is an example of using 5x of leverage.

If the price of the house appreciates 1%, the homeowner’s equity goes up by 5%.

In an economy where prices are going up i.e. inflation, such as in the last 50 years for majority of countries in the world, this works well as the homeowner’s equity does not fall below the loan taken from a bank.

However, when prices fall such as in the Global Financial Crisis of 2008, homeowners could go underwater, meaning there is negative equity in their homes. If these owners sold their homes with negative equity, they would have to cough up extra money at the close of the deal.

This is a result of leverage exacerbating the picture when prices are falling.

While leverage gives an extra kick to profit potential, it can work both ways and decrease equity in a home 5 times when home prices are declining.

The moral of the story is to use leverage when asset prices are increasing and not to use it when prices are declining.

Since real estate is inflation-proof, you should consider buying with leverage

Since many countries around the world has been experiencing inflation, you would be happy if you bought real estate anytime in the last 50 years.

History of home values
History of home values

Looking at Robert Shiller’s chart on real estate prices in the US since 1890, it’s evident that home prices are a good hedge against inflation.

Not only has real estate prices kept pace with inflation, it has exceeded the inflation rate in the last 18 years.

For homeowners who believe that real estate is one of the best ways to riches, they intuitively know that real estate is highly correlated with inflation and that is true. It is true not only in the US but globally.

The following few charts from the Economist show home prices generally rising over the last 50 years.

House prices in US and Canada

With a lot of China hot money, Canada home prices have been on a tear, with barely a major correction in the last 40 years.

On the other hand, the US experienced a significant correction during the 2008 global financial crisis.

Economist's America home prices
Economist’s America home prices

House prices in Europe

Spain saw a very steep rise followed by a crash while Switzerland and Germany’s performance has been very poor compared to other European countries. Most of the countries such as Italy, France and Sweden are bunched in the middle.

Economist's Europe home prices
Economist’s Europe home prices

Asia-Pacific home prices

Most Asia-Pacific home prices have been rising with one notable exception of Japan where the price index has actually gone into negative territory.

This is a classic case of deflation rearing its ugly head in an economy and causing havoc on a whole generation of home owners.

Hong Kong is the other case where there has been uncontrolled increase in house prices. It is anyone’s guess on whether there can be continued appreciation, with some saying the land-locked nature of country lends itself to house price appreciation and others saying the bursting of the bubble will not be pretty.

Economist's Asia Pacific home prices
Economist’s Asia Pacific home prices

Most stark is the real life situation of Japan where deflation was allowed to take root, and house prices have been on the decline since the turn of the century.

This is a lesson to be learned that when there is inflation, you should own real estate with a mortgage. But what happens when there is no inflation? Or when there is deflation? Should you be using leverage to buy real estate?

Japan: How deflation affects real estate

The chart above should give you some insight into how deflation can destroy an investors equity in real estate.

Historically, Japan’s economy and stock market peaked in 1989 and have been stuck in deflation ever since. In real terms, house prices have been dropping for the past 25+ years.

One reason for this is this is the leverage taken by real estate investors in a deflationary economy.

This causes a negative compounding effect on wealth.

If Japanese investors had no leverage on their real estate, then house prices in real terms would be flat. However, it is dropping because they are using leverage.

Look at the following chart to see how deflation causes a fall in prices of the general economy. Everything from stocks and real estate to food and clothes go through a decline.

Results of deflation
Results of deflation

While most people naturally assume that inflation is a permanent fixture in an economy, it isn’t.

The following chart of US inflation should show you that consistent inflation is a more recent phenomenon.

This would also be the reason why real estate prices has been on an uptrend over the last 50 years.

US historical inflation rate
US historical inflation rate

One thing to always keep in mind then is that inflation is not always positive. Real estate is an inflation hedge with prices and rents rising in tandem with inflation, but if there is a regime change to a deflationary environment, prices and rents may not continue their upward bias.

Rental income: How cash flow rises and falls with inflation

With inflation at the back of our minds, let’s recognize the fact that real estate investors invest with the aim of receiving a steady stream of cash flow and a valuation boost when they sell the asset.

Tenants are usually locked into a contract where rents rise together with the rate of inflation.

The following chart shows how rents will be in 5, 10, 20 and 30 years depending on the rate of inflation assumed.


Inflation scenarios and impact on rents
Inflation scenarios and impact on rents

At 3% inflation, a rent of $766 today will turn out to be $1,859 or about 2.4 times higher in 30 years.

However, at -3% inflation (or 3% deflation), the same $766 will turn out to be $307 in 30 years or a whole 60% lower.

This is not constrained just to rents. Prices of real estate can also fall, as we have seen in the case of Japan.

For a real estate investor, the -3% inflation rate is very dangerous because while the cash amount you receive becomes smaller and smaller every year, the mortgage of $2,000 per month, for example, on your property remains at that level.

With lower rents paid to you as the landlord every year, you’ll require more years of rental receipts before the full mortgage payment can be paid off.

This is why leverage used on a property investment during periods of deflation can be problematic.

How does deflation affect debt?

Once again, a table is very helpful in understanding how deflation affects debt.


Results of deflation
Results of deflation

On the left side where cash is, this can be compared to the $100,000 mortgage loan you took for your house. When there is deflation, that number or the loan you took for your house isn’t adjusted downwards. The bank doesn’t have mercy and compassion in this regard by reducing the $100,000 to $80,000. You’ll have to pay off this $100,000 amount come rain or shine.

On the right hand side, you’ll see that Rent falls over the long term. As a property investor, this means that your liabilities remain at for example $100,000 but your cash flows generated from the property falls.

Deflation can thus be looked at in two ways.

  1. The price of goods, services and the amount of rent you receive decline; and the amount of debt remains unchanged.
  2. Alternatively, it can be viewed as the value of debt appreciating

Whatever way it is put, a mortgage taken during in a deflationary environment can destroy your wealth.

Deflation is not always bad (contrarian view)

Some people may raise an issue with the view that deflation is definitely and categorically bad for real estate investors. These people say that it isn’t always bad and this is why.

When there is deflation, a real estate investor’s cash flow falls from say $5,000 to $4,000 and he is less well off. But the price of food, clothing, transport and daily necessities also fall, so on a net-net basis, the investor isn’t really less well off.

At the same time, fire insurance, cost of ownership and management of a real estate property will also be adjusted down.

At the end of the day, the investor isn’t in a truly worse off position since what goes into his pocket (rental less expenses, insurance, maintenance and general costs of running and upkeeping the property) remains relatively constant.

Why worry about deflation?

The last 50 years has brought about an unprecedented period of consistent inflation which has been beneficial for the economy.

Real estate investors have also benefitted as the economy grew. Unfortunately, complacency also grew as a whole generation of people become accustomed to this experience of growth.

With recency bias, the last 50 good years has led many to be myopic with their real estate investments, assuming that prices and rents will always continue to rise.

As the Americans saw during the great depression, there can be a painful period of adjustment when prices fall.

Unfortunately, the adjustment comes after a period of high leverage, as some see the world to be in today.

What should you do?

Is selling all that you have and renting the way to go then?

That may not be the most appropriate course of action to take, but everyone should be cognizant that in today’s low inflation world, there might be a chance that the central banks lose their fight against deflation.

Despite the money printing, stimulative monetary and fiscal policies, inflation has remained stubbornly low and investors’ actions have caused asset prices to be elevated.

Will the last 50 years of asset price increase end in a great depression style downturn? I do not have a crystal ball and am not sure. However, I find Howard Marks and Ray Dalio’s pieces on the economy very enlightening. Both don’t purport to predict the future (nobody knows anyway), but they illuminate people’s understanding by diagnosing where the world is in the business cycle.