The Influencers: How Central Banks and Money Supply Affect Your Real Estate Returns

Here is what you will learn in this article:

• The compelling dynamics of residential real estate investing even in an environment of expanding money supply and debt
• The origins and evolution of money, from ancient coins to modern fiat currencies
• How the shift from the gold standard to fiat money system changed the nature of currency
• The role of fractional reserve banking in creating money through bank lending
• The impact of excessive money printing and national debt on inflation and purchasing power
• How these monetary forces influence residential real estate investing and the importance of managing debt and rental income streams

As someone deeply involved in residential real estate investing, I often reflect on the fundamental role that money plays in facilitating these transactions. The very concept of money is something we take for granted in today's world, but its origins are quite fascinating.

The first coins we know of were minted around 600 B.C. in the ancient Greek city of Lydia. These early coins were made of electrum, a natural alloy of gold and silver. From there, coins made of precious metals spread across the Mediterranean world as a more convenient form of exchange than the barter system.

For centuries, coins remained the dominant form of money, until paper money was developed in ancient China during the Song Dynasty around 960 A.D. Paper bills represented a Certificate of Deposit for a stack of cash locked away by the government. This gave way to the modern fiat currency system we know today, where money derives its value from the stability of the governing authority.

For most of modern history, currencies derived their value by being backed by an underlying commodity like gold or silver. Under this "gold standard" system, every dollar in circulation was technically redeemable for its value in gold held by the governing authority. This acted as a natural check on deficit spending and money printing by the government.

However, in 1971 this all changed when President Richard Nixon announced that the United States would unilaterally cancel the direct convertibility of U.S. dollars into gold due to economic pressures at the time. This decision effectively took the U.S. dollar off the gold standard for good, with other major nations following suit in leaving the gold standard-backed system.

In this new monetary reality, fiat currencies like the U.S. dollar were no longer backed by gold or any other physical commodity. Rather, their value was derived solely from the credibility of the issuing government's promise to maintain confidence and acceptance of that currency within their economy.

This ushered in our modern system of purely fiat money, no longer constrained by the limited supply of commodity reserves like gold. While providing more flexibility for governments and central banks to manage money supply based on economic conditions, it also opened the door to higher inflation risks if that money supply was mismanaged over time.

The shift from a commodity-backed system to a fiat monetary standard was one of the most consequential events in financial history. It fundamentally changed the nature of currency and money itself into something backed only by the full faith and credit of sovereign nations' credibility. This placed increasing importance on prudent fiscal and monetary policies to manage fiat money supply growth and maintain a currency's purchasing power over time.

However, one of the most profound evolutions in the nature of money has occurred over just the past few decades - the rise of a credit-based monetary system where money is effectively created through bank lending. Today, the majority of money in circulation is not physical currency but rather is digital credit created by banks when they issue loans.

The process works like this: When a bank loans money to a homebuyer for example, it is not simply redistributing existing funds from its reserves. Rather, the bank is creating brand new digital money through the very act of issuing the loan.

Banks are able to do this because of fractional reserve banking. Regulations only require banks to keep a small percentage of their total outstanding loans on hand as cash reserves, typically around 10%. So, if a bank receives $1 million in new deposits, it can then turn around and issue $9 million in new loans, instantly creating that $9 million as brand-new money.

The money created through the loan is then deposited into the homebuyer's account and can circulate through the broader economy when they use it to purchase the home. The same process occurs when the government issues bonds to fund spending - new money is effectively created out of thin air by boosting banks' reserves.

This system allows money supply to expand quite rapidly to meet economic growth and demand for credit, but also introduces potential instability if credit issuance occurs too excessively. The banking sector's money creation is governed by reserve ratios and capital requirements set by central banks.

Another major risk from the current debt spiral and excessive money printing is a steady erosion of the dollar's purchasing power for average Americans. While the intrinsic value provided by assets like homes, cars, and food remains essentially unchanged over time, the number of dollars required to obtain those assets increases as more dollars are created and put into circulation.

To illustrate this, consider what $200,000 could purchase two decades ago versus today's inflated dollar supply:

In 2002, $200,000 was enough to buy:

- A median-priced $150,000 home

- A $15,000 new car

- 6,667 pounds of $3/lb organic ground beef ($20,000)

- With $15,000 remaining for other expenses

Fast forward to today, and that same $200,000 buys vastly less due to dollar devaluation:

- Can only afford a $200,000 home at inflated prices

- Gets you a $30,000 new vehicle

- Only 1,333 pounds of $15/lb organic beef ($20,000)

- Leaving $0 remaining for other costs

The value and utility provided by the home (shelter), car (transportation), and beef (nourishment) did not fundamentally change over that period. What changed was the number of devalued dollars required to purchase those same assets due to the excessive new dollars created.

This loss of purchasing power is the inevitable result of unconstrained money printing and deficit spending. It highlights why prudent long-term investors must mitigate this corrosive effect by owning hard assets like real estate whose intrinsic value can better keep pace as the dollar’ worth erodes.

Another critical monetary force that impacts real estate and other investments is the rapidly expanding national debt. The U.S. government debt now exceeds $35 trillion and continues growing at an unsustainable pace through deficit spending.

With an average interest rate of 3.22% on the outstanding debt according to the latest data, annual interest costs have already surpassed $1 trillion per year. And these interest expenses will continue ballooning as rates normalize higher from historically low levels over the past decade.

To pay these massive interest costs, the government must increase borrowing even further by issuing more bonds. This drives up demand for credit, effectively tightening monetary conditions as more money chases a limited pool of funds. The Federal Reserve is then put in a difficult position - keep raising rates aggressively to counter inflation or pause to prevent soaring interest expenses from exacerbating the debt spiral.

For those of us invested in residential rental properties, these national debt dynamics pose risks that must be proactively managed. Excessive money printing and interest costs could further devalue the U.S. dollar and stoke even higher inflation. This erodes the real value of rental income streams that can be slow to reset based on longer-term leases.

However, residential investors like us do have some levers to pull to navigate this environment. As leases roll over, we can increase rents to keep pace with inflation and prevent our income streams from being eroded in real terms. Additionally, examining our capital structures and locking in longer-term fixed-rate debt can mitigate risks from rising interest rates.

This is also proving the massive importance I have always placed on investing in high-performing properties. Leveraging these historically proven inflation hedges like well-located income properties is also wise, as higher inflation should bid up real estate values over time. For us leveraged investors, inflation allows us to pay back fixed mortgage debts with devalued dollars in the future.

Think about how much it used to cost to go out and have dinner with the family 10 years, 15 years, 20 years ago compared to now. The value of dinner, the pleasure of breaking bread, having a good conversation, and being with loved ones has not changed. You just have to give many more of those little green pieces of paper for the same pleasure.

As a real estate investor, I must carefully monitor indicators like inflation, interest rates, and lending standards which are all influenced by this credit-based monetary model and its impact on money supply. I do that for all our clients and subscribers so you don’t have to, but awareness is important so you can make better decisions.

An increasing supply of money chasing a limited number of assets like real estate puts upward pressure on prices. However, too much expansion can lead to asset bubbles and an eventual credit crunch or recession when lending standards are tightened.

Ultimately, while the national debt load poses risks, residential real estate investing maintains compelling dynamics even in this environment. Investors able to nimbly adjust rental rates, manage debt obligations, and acquire properties at attractive cap rates and valuations can still generate strong risk-adjusted returns. Our community is most attuned to these interplays between debt, inflation, interest rates, and housing fundamentals, helping us to be best positioned.

Disciplined investors like us must stay abreast of these monetary forces driven by the fractional reserve banking system to successfully navigate residential real estate markets over various credit cycles.

Residential real estate values are inextricably linked to the money creation policies of central banks and private lenders. While money itself has transformed dramatically from antiquity to today's digital credit system, the forces of supply and demand still hold true.