Does inflation help or hinder leveraged investments ?

I've read a debate on another forum where they are discussing whether inflation helps or hinders investors.

There seem to be two arguments:

The first argument says borrowing money now and paying it back using tomorrow's dollars makes investment great for people using leverage (borrowed money). This works because inflation means that it's easier to get $1000 in the future to pay back our loan than it is to get that same $1000 today (our rate of pay would have increased in the future, making the amount of effort required to earn $1000 much less then than it is today). Or, flip that around and it says, the future value of $1000 is less than it is today (hence it costs us less to pay it back at some point in the future). This argument implies that the higher the rate of inflation, the better it is for people with loans.

The other argument says that your investment returns have to "keep up with inflation" to maintain their value. For example, if you had $1000 in cash today, it would have less purchasing power in 10 years time because of inflation. You money is decreasing in value over time. If you were to invest that money in the bank - and if your money wasn't growing faster than the rate of inflation - then your money will also decrease in value over time (although at a slower rate than if you hadn't invested it at all). This argument implies that the lower the rate of inflation, the better it is for people investing.

So, which argument is correct ?

Well, I did some thinking about it, and some modelling using a spreadsheet, and my analysis has concluded this:

They are BOTH correct !!

(don't you hate that ? )

Both arguments actually have an impact on the future returns of your investments. Borrowed money gets cheaper to pay back over time, but the real value of your investments decrease over time - both due to inflation.

In fact, my spreadsheet (which I won't upload right now, because it would take me too long to explain it all) shows that there is a point of inflection where inflation changes from a help to a hinderance. Where this point actually sits depends on a multitude of variables, but let me explain my basic scenario.

$20K cash put in as a deposit
$80K borrowed
$100K purchase price
30 year interest only loan payments, with full principal paid out at the end of 30 years.

I calculated the Net Present Value (NPV) of the payments over 30 years, and compared this with the NPV of the total returns (growth + income, ignoring tax) over the same 30 years. I then changed the interest rate and inflation rate, and each time I had the spreadsheet solver calculate what the minimum total return each year was to ensure that the NPV of returns was at least equal to the NPV of the payments.

I then plotted those minimum return values in a chart against the interest rates, and it showed that for lower interest rates, higher inflation improved the returns, while at higher interest rates, higher inflation hindered returns.

In my scenario, the point where the inflection occurred was when interest rates were around 8%. I haven't done enough analysis to work out how this figure changes as the assumptions in the scenario change - and it's certainly not a fixed point.

More importantly, you need to understand that the compounding growth makes the returns increase exponentially, whereas the interest only loan without any capitalisation of interest does NOT grow.

This means that the effects of inflation operate differently on the loan than they do on the returns,

If you graph the NPV of the loan payments as inflation increases, you will find that the curve has an asymptote - such that further increases in inflation result in smaller and smaller increases in NPV of the payments. In other words, there is a limit to the effects that an increase in inflation will have on the NPV of the loan payments. For example, the change in inflation from, say, 1% to 2% has a much much larger impact on the NPV of the returns than a change of, say, 8% to 9%.

At the same time though, the effects of inflation on the total returns of the property also have a limiting factor - higher inflation limits the returns and restricts them to an asymptote of their own. Thus, as inflation increases, the NPV of the returns of the investment tend (down) towards a fixed number.

The trick is that, provided there is sufficient gap between the returns and the payments (ie you are actually making money out of the investment), then the limiting factor on payments versus the limiting factor on returns will cancel each other out to a certain degree - but you will still make a return.

Given that an increase in interest rates make the payments a larger part of the equation, it makes sense that there would be a point at which high enough rates tends to change the impact of inflation on returns - hence the inflection point.

In summary - my charts showed that the benefit of higher inflation on payments was less than the impact of higher inflation on returns.

With low interest rates (below the inflection point, wherever that is), the higher the inflation, the better off you are. With higher interest rates (above that inflection point), the lower the inflation, the better off you are.

Without further analysis to discover what variables determine the location of that inflection point, it is difficult to make any meaningful conclusions about what to do in different inflationary environments. However, my figures do seem to indicate that when there is growth to be had, lower inflation is generally a better thing for you.

Naturally, the whole things gets even more complicated when you start to analyse the interrelationships between interest rates, inflation and investment growth as well - I've been working with these variables as if they were fully independent - but we know they aren't.

Executive summary: it's really difficult to make any kind of accurate analysis that doesn't involve so many assumptions so as to make it all meaningless ... even so, I will summarise by saying that inflation has both a positive effect on loan values, and a negative effect on investment returns. The question as to which effect is greater requires more analysis, but my gut feel from my simplistic modelling so far indicates that the impact on investment returns will be the more significant - hence overall, a lower inflation rate would seem to be a better thing for growth investments.

Comments ?