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It is imperative that the long-term real estate investor prepares for the inevitable reality of inflation. The long-term “buy & hold” real estate investor anticipates inflation for subsequent profit to be realized. Further adding a heaping (but manageable) dose of leverage (mortgage debt) ultimately enhances the positive effect of inflation to the investors overall return on investment.

These two powerful forces combine to continually bolster the real estate investor’s net-worth, in the long-term.

During times of inflation, you want to invest in hard assets, such as REAL ESTATE, that protect you from the HUGE loss of purchasing power that inflation brings. Those holding cash in savings accounts and GICs become cruelly punished by inflation. Alternatively however, real estate investors continue to steadily build wealth during inflationary periods while savers become losers. And seeing as the Bank of Canada is mandated to do everything in its power to keep inflation in positive territory, it might be a good idea to consider adding real estate investing to your investment portfolio.

How powerful is inflation and leverage you might be asking yourself? Consider the following example:

Lets say “Joe” was roaming around London, Ontario with exactly $163,400 in his bank account in the year 1980.

Joe wants to buy a home for his family in 1980.

If Joe was to buy an executive detached two storey HOME in LONDON ONTARIO in 1980, it would cost Joe approx $81,200 according to the Royal Lepage database.

Joe could afford to buy exactly TWO of these houses and pay all cash.

With the exact same $163,400 cash in 2009, Joe can now only buy just a little bit over HALF OF ONE HOUSE. According to Royal Lepage that exact same house now is valued at $268,500….and 25 years from now, Joe’s house may cost well over $1 million.

This is because of inflation.

That explains inflation, but what about Leverage?

Lets now assume that instead of Joe being flush with $163,400 cash, Joe unfortunately had zero dollars in savings but really wanted a house in 1980 (like a lot of people). He really wants a roof over his head. He also wants to own, not rent. Ultimately to purchase his home Joe decides to take out a 100% interest only Line of Credit, 100% nothing down financing of this executive detached two storey home in London Ontario.

Joe has just bought this $81,200 home with 100% financing, interest only payments.

Tremendously risky way to invest in property. Very risky if you ask me. Let’s keep going though for the sake of this example…. Lets generously assume the interest rate averaged 10% a year on this Line of Credit he is responsible to pay (some years interest rates were really really high like in the 80s, some really really LOW like in 2009) for arguments sake, lets pick 10% it has averaged over this time from.

$676.67 would be his monthly payments on his LOC.

His $81,200 LOC never gets paid down, but doesn’t it seem smaller today as the underlying property now worth $268,500? Inflation helped Joe.

Furthermore, what if Joe bought this home as an investment property and rented this 100% no money down house right from the get-go? According to the Royal Lepage database, Joe could receive $600 a month rent in 1980 for this house each month to service his $676.67 payments. He is NEGATIVE CASH FLOW. Negative cash flow is terribly dangerous and I wouldn’t recommend it but lets for the sake of this example keep going as it yeilds a good illustration at the end.

Joe’s first few years would have been very tight, as the first few years always are when you buy a rental property. But an interesting thing happens each year that seriously helps the real estate investor – rent climbs, annually. Has history proven that real estate market rental income is indexed for inflation too? Absolutely it has.

In 2002 a STANDARD Two Storey (not even an executive two storey) rents for $1325 according to Royal Lepage. The Royal LePage database unfortunately doesn’t provide the market rent amount for 2009 executive two storeys but I’m willing to wager that in 2009 an executive two storey rents for far more than this. So has rental income for Joe increased over the years because of inflation? Undeniably yes!

Therefore, does inflation help the holder of real estate in the long-run? Yes, it certainly does. Does leverage too?

Well, lets see… Not only is Joe’s property indexed for inflation, but so is Joe’s rental income. Joe’s property increases in value, Joe’s monthly income from rent increases, and Joe’s once large, risky, interest only $81,200 LOC seems stragely low all of a sudden today doesn’t it? Remember Joe originally financed the home 100%, no money down. Even though the balance hasn’t changed, $81,200 sure doesn’t buy what it used to… And the monthly payment’s Joe is responsible for ($676.76) sure is small now compared to today’s $1325 rental income.

Joe’s unchanged limit and balance on his Line Of Credit has been beaten down by inflation and reduced to a small minuscule amount in comparison to the underlying property. And that was with what is considered the most risky financing possible: 100% interest only payments (meaning no mortgage pay down) and 100% financing (meaning no down-payment).

Inflation hurt the bank that lent Joe the Line of Credit (LOC) because the purchasing power of the $676.76 a month that the bank received from Joe gradually became reduced over time and lost the monetary power it previously held.

Inflation and leverage helps Joe the investor.

Now, consider where Joe’s net-worth would be if he used a down payment on the house in 1980? And what if Joe structured the mortgage payments on a regular declining balance amortization over 25 years like most people? Well, one things for sure, after 25 years there would be no mortgage left at all… But the underlying asset (real estate investment) would certainly have escalated in value.

So in the end, despite the rampant fear of leverage and inflation it pays to welcome those two phenomenons as a real estate investor and manage effectively to steadily build long-term wealth through real estate investing.