EEB Presentation On

Deflation – How a mortgage can destroy your Real estate wealth?

S.No Names Roll No

1. Rashi Gupta 201610111

2. Shashank Sharma 201601329

3. Abhishek Wakaley 201601136

4. Baljeet kaur 201600216

5. V. Manasa 201600124

Group no - 9

Submitted to: Dr. Shyam

Deflation is a fall in the general price level or a contraction of credit and available money .This means there is less money in circulation, which generally makes holding it more valuable. It also refers to a fall in the general price level of goods and services.Deflation in of itself is not dangerous. What makes deflation dangerous and deserving of the prejudices of many economists is the use of leverage in an economyCurrently, the US has a credit-based economy which is highly leveraged. This is primarily due to the amount of debt and money creation .Debt-to-GDP is a good indicator of the leverage employed in an economy. A higher number means more leverage, and a lower number mean less leverage.. Too much debt reduces the country’s ability to grow.You can equate the Debt-to-GDP leverage in an economy to the leverage used to buy real estate via a mortgage.

What is deflation?

•A high degree of leverage can be used•Real estate is inflation proof•Creation of cash flow•Appreciation potential•Reduction of debt over time in real terms•A limited supply of land•Tax benefits•With zero inflation, the advantages of real estate would be limited to only the tax benefits and the limited supply of land. With negative inflation (deflation), your advantages of owning real estate with leverage would turn into disadvantages.•Mainly there are 5 factors why real estate is a powerful asset class to create wealth but deflation affect these factors.•Don’t use leverage with a negative inflation rate(deflation). This would cause a negative compounding effect.

why Real Estate is such a powerful asset class to create wealth ?

How does deflation affect your use of leverage when investing in real estate?

Leverage is an important tool in the world of finance. It allows you to take a small amount of

money and use it control an asset worth a larger amount. If you go out and buy a house and use a

mortgage to do so, then you are employing leverage.

For example, if you buy a $100,000 home, you can borrow up to 80% of the purchase price or

$80,000 while only putting down $20,000. This is an example of someone using 5 times

leverage, meaning that for every 1% the home appreciates, the homeowner’s equity goes up 5%. 

This works out well when home prices are going up. However, as most people know from 2008,

that doesn’t always happen.

In 2008, the housing bubble burst causing home prices to drop, and in some areas, they dropped

significantly. This kept a lot of homeowners underwater, meaning that they had negative equity

in their homes. If they sold their homes they would have had to come up with extra money at the

closing. This happened in part due to a drop in home prices and partially due to homeowners

putting down less than 20%.

The Pace of Real Estate with inflation If you had bought real estate 50 years ago, you would be happy with the performance of your investment. Here is a chart to show real estate prices in the US since 1890.

Not only have real estate prices kept pace with inflation, but in the past 18 years, homes exceeded the rate of inflation by a large amount. However, if we remove the prices from 1997 to the present, then the picture seems a bit clearer. Real estate is a great hedge against inflation. It tends to move with the inflation rate.Fortunately for homeowners and real estate investors, real estate is highly correlated with inflation. If you remove the financial crisis, we have had a non-stop period of 50+ years of inflation to boost real estate prices. This is not only true in the US, but globally as well.

HOUSE PRICE INDEX

Rental Income – How cash flow from real estate increases and decreases with the rate of inflation

•If a property is managed properly, the cash flow generated from an investment in real estate should be consistent. It should also be pegged to the rate of inflation.

•When inflation is positive, this is great for real estate investors.

•Negative inflation can pose a problem for investors. Rents do not always go up, they can drop to keep pace with negative inflation as well.

•If you do not have a mortgage, then this is just a minor problem for you. However, if you have a mortgage on your investment property, then this might pose a problem.

How does deflation affect debt?

•Deflation is reduction in prices of goods also termed as negative inflation. This can be

positive as well as negative.

•If you held cash for the past 50 years, your currency would be worth 95% less than it

was 50 years before. This is because the value cash declines over time through inflation.

•Debt works in a similar manner over time, the value of that debt declines in the same

way that cash does. Over the past 50 years, the value of Rs.100 in debt would be worth

less than Rs.10 in today’s currency value. Hence, using leverage during inflationary

times causes debt to be worth less over time.

How does deflation affect debt?While inflation decreases the value of debt over time, deflation does the opposite. It causes debt to be worth more over time. This is how a mortgage can destroy your real estate wealth.For E.g.

As we can see the prices of goods and services decrease in value, and the price of debt remains unchanged. Hence, it is necessary to reduce your debt if there is negative inflation .