Mitch Wasterlain, CEO of CAPFUNDR, was featured in this Forbes Article

To get rich the way real estate billionaires do: (1) Buy assets. (2) Finance with fixed-rate debt. (3) Wait for inflation.

Leveraged real estate has created many an American fortune. It worked in the late 1970s, when rising inflation caught lenders flat-footed and delivered windfalls to property owners. It could work again, if fiscal policy reignites inflation. That could happen. President-elect Trump has in mind trillions of dollars of tax cuts and infrastructure spending. In fact, his fiscal policies could do more to build the Trump family's wealth than all the business self-dealing that the press and good-government watchdogs are obsessing over.

Unexpected inflation creates winners and losers. Borrowers--you, if you have a fixed-rate home mortgage--take home gains. Lenders--you again, if there are long-term bonds in your retirement account--suffer losses.

Big investors bet on rising prices by acquiring debt-financed apartment buildings and commercial real estate. Small investors can do it by owning real estate investment trusts. And what better time to own REITs, says Robert G. Smith, who oversees $12 billion in portfolios at Sage Advisory in Austin, Texas, than when you have "one of the most prolific builders as your president."

Investor excitement following the election came in a spurt for some sectors. Drugmakers and banks enjoyed a relief rally on the expectation that regulations will be relaxed. Companies that would capture road-building dollars, like Caterpillar and Vulcan Materials, had their run-ups.

The postelection rally left real estate out. Equity REIT shares are now off 14% from their July peak, according to the National Association of Real Estate Investment Trusts.

What's going on? Income investors, despairing of the tiny yields on Treasurys, were turning in desperation to riskier assets like REITs. When the yield on the ten-year Treasury started an ascent from its 1.4% low in July, REIT yields climbed as well. That sent their share prices down. But perhaps investors have confused nominal and real yields.

Inflation raises nominal yields on conventional mortgages and bonds, as bondholders seek compensation for being repaid in shrunken dollars. But an income stream from real estate is closer to a postinflation return, explains Jean-Michel Wasterlain, chief executive of Capfundr, a New York City real estate fund manager. A rising CPI eventually pushes up both the rents that a property owner collects and the price that the asset would fetch in a sale.

Wasterlain has data to prove the point. He compared yields on Treasury bonds and net rental yields (called "capitalization rates") on investment real estate over the past 37 years. When inflation drove up the nominal yields on bonds and drove down bond prices, it did not push up real estate yields or push down real estate prices in like manner. Average cap rates have mostly kept inside a range of 6% to 9%, even as the yield on the ten-year Treasury lurched between 2% and 14%.

Inflation expectations are rising (see chart, above). Predictably, the bond market is in retreat. But property values are holding up, Wasterlain says. Indeed, far from damaging property values, inflation would help property owners who have paid for their assets in part with fixed-rate debt. Their rents climb, but their mortgage payments don't.

Inflation winners should include equity REITs (the ones that own buildings, as opposed to mortgages). The average equity REIT has debt equal to 31% of the value of its assets, according to the REIT association. A lot of this debt is at fixed rates, Wasterlain says.

The largest REIT exchange-traded fund is Vanguard's (VNQ). You could also look for an inflation shield in funds that own commodities (DBC), gold bullion (IAU), goldmine shares (GDX) or inflation-protected Treasury bonds (SCHP).

The borrowing class includes homeowners. "If you believe that Trump is going to do what he says he's going to do" with spending and tax cuts, says Wasterlain, "you should leverage your home. Borrow as much as you can at 4% because in a few years interest rates will be higher and property values will be higher."

Debt, of course, comes with risk. Expected inflation may never arrive; past warnings about inflation, made on these pages and elsewhere, have not yet been vindicated. REITs have their own hazards, reflecting the fact that they are more sensitive than property values are to what's going on in the stock market. The prices of equity REITs crashed 67% in the last downturn.

But you can get some reassurance from the fact that one important person has reason to root for inflation's return. Donald Trump has much of his net worth tied up in real estate, and he is not hesitant to borrow. The FORBES wealth team estimates that his fixed-rate debts add up to $800 million.

Originally posted on Forbes on December 12, 2016 by William Baldwin


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