The Real Cost of Inflation to Property Investors (And What You Can Do About It)
Inflation and interest rates are on the rise. Should property investors venture out? Or is it time to hunker down? Find out here.
If you’re at all invested or interested in property, the words “interest rates” seem to be kind of haunting everyone these days.
The RBA has been increasing the cash rate this year. Naturally, people are concerned about interest rates. They’re concerned about its impact on cash flow not just for investors but for anyone who has a mortgage or is dealing with any form of property.
Now with such a “scary” financial environment… some investors are quivering on their toes. They want to keep their hard-earned money in the bank.
But here’s the thing: this is the wrong move when it comes to tackling high-interest rates and inflation.
And in this article, we’ll tell you why this is the wrong move… and what you should be doing instead.
The Link Between Inflation and Interest Rate
To understand the right way to deal with high-interest rates we must first find out what’s really going on.
You see, interest rates are going up in response to higher inflation. And inflation is high because of several factors, like the effects of COVID-19 and the war in Ukraine on the global supply chain. Because of these factors, the supply of items like basic commodities and raw materials has stalled. And since demand continues to pick up, the prices of existing goods also go up.
That’s why inflation is high.
But what has this got to do with interest rate hikes?
Simple. This is the government’s response to address inflation. The government basically tries to limit how people spend to cool inflation and keep the prices of goods lower.
Interest rates are increasing to deflate inflation and help normalise the supply and demand chain.
Eventually, when the government succeeds in making the economy healthy, it will revert interest rates to acceptable levels. But until it reaches that…
The RBA will continue to increase interest rates for the sake of combatting the high inflation rate.
Nominal vs Real Interest Rate
There are two kinds of interest rates: nominal interest rate and real interest rate. And as property investors, we need to know the difference between them.
Nominal interest rates are the headline interest rates. This is the kind that you see from the banks. While the RBA can dictate the benchmark interest rates, various lenders can define just how much interest rates they will charge you to invest in property.
On the other hand, the real interest rate is the difference between inflation and the nominal interest rate. The real interest rate actually gives us the real cost of borrowing. If inflation is higher than the nominal interest rates… the real interest rates drop below zero.
For example, if the inflation rate is at 10% and the nominal interest rate is at 5%… then you’d get a -5% real interest rate.
The Real Cost of Capital
Now, the real cost of capital is all about effectively determining the efficiency of the return of your money versus the cost of doing nothing. In other words, it’s inflation versus the cost of interest rates versus the total return that you can expect to get out of a certain asset.
With this, you can really start to look beyond the cost of your mortgage going up.
It means you should also determine the real impact of inflation on your cash and on interest rates. Because you might actually find a good opportunity for an alternate play… and get your cash growing despite the higher interest rates.
The opportunity that we’re talking about here is arbitrage. Let me discuss the concept further below.
The Benefits of Arbitrage
If inflation is higher than the nominal interest rates or is growing faster than the nominal interest rates… you have the opportunity to make money just by deploying capital. And that is the simplest way to understand arbitrage.
Arbitrage is really interesting because there are so many types that you can take advantage of.
In the financial markets, arbitrage is more common through foreign exchange trading. For example, the value of an Australian dollar in today’s market versus the value of the British pound differs. And you can take advantage of that difference, even if it’s only a fraction of a percent. The same goes for any other currency in the world.
You can benefit from such differences by trading currencies in different markets at different times of the day. That’s a classic financial arbitrage.
Then there’s also geographic arbitrage. This is where you will take advantage of cheaper prices of goods and services in other countries.
Here’s an example: One of our team members used to live in Hong Kong. But he flies to Vietnam to get his suits made. Why? Because if he wants a really nice suit done, it will cost him thousands of dollars. But if he flies to Ho Chi Minh, a custom suit can be done for a couple of hundred bucks within 24 hours.
So, despite the cost of the flight and other expenses, it makes sense to get a tailor-made suit since he still saved about 50%.
Now how does arbitrage apply to property investing?
Simple. It’s all about looking for opportunities.
Look deeper into the markets – there are markets in which we’re currently buying properties for our clients. We’re buying high-quality assets that you can buy for less than the replacement value. And that’s arbitrage!
If you can pick up a property for less than the cost… then that’s a good move.
Keep Searching for Opportunities
It’s critically important for investors to think about the real cost of inflation. Because if you’ve got cash sitting in the bank doing nothing… then the only thing that’s happening to your money is it’s losing value.
So, what should you do instead?
Make sure you have just enough in the bank for emergencies… then deploy the rest for arbitrage plays.
You don’t really need to go out of your way and take advantage of geographic or financial arbitrage. There are plenty of opportunities in the property sector that you can benefit fro