According to the notes,
“real estate also performs poorly during deflationary times, particularly when the investment is financed with debt”
Why is it particularly when the investment is financed with debt? Shouldn’t the performance also be poor when the real estate is financed with equity?
Say the apartment costs 10m, your cost would be 10m, no matter you pay with debt or equity, no?
Please help guys, many thanks.
if u have read the fixed income part 2 reading on repurchase agreements, you would have discovered adding leverage to a portfolio always magnifies both returns and losses on the prtfolio. this is why real estate will perform poorly in deflationary periods- i.e where there is likely a recession because it is heavily financed with debt although equity financing will as well result in losses. the idea is real estate investment experience losses during recessions/deflation.
So if we have deflation then rents (let’s assume the real estate asset is apartments) will drop (holding everything else constant) - this means that there is less income to service your debt with, so… less income to the owning entities. The problem is that you have a fixed principal amount but the CF that the asset is producing is dropping (not rising as would be expected in a sustainable inflationary environment).
Cash is worth more in deflationary times (price tomorrow less than price today) and your variable cash flow (rent) is generating less of it than the fixed amount you owe (mortgage/debt). Therefore, you’re losing out.