Is Real Estate a Good Hedge Against Hyperinflation? Greg’s Note: When the market is in a downturn wise investors look for a hedge to protect their money and maybe even profit from a slow economy. Dr. Krassimir Petrov of the American University in Bulgaria is offering his thoughts on real estate as a potential hedge during an expected increase in inflation. Is housing really the right place to hedge your bets? Enjoy, and send your comments to the managing editor here: greg@whiskeyandgunpowder.com Whiskey & Gunpowder
January 24, 2008
By Dr. Krassimir Petrov
Blagoevgrad, Bulgaria
Over the Hedge
AS THE MARKETS CONTINUE BUCKING WILDLY, and the fed slashing rates with more cuts to come, we can expect more volatility with our currency. The U.S. will likely spin into a long era of high inflation. The coming years will look like the 1970s. There is also a good risk of hyperinflation, which is a particularly severe bout of high inflation. Thus, the vital question for every investor is how to hedge, or protect, your wealth against inflation. Some, especially realtors, urge to hedge this risk with real estate. So should we really hedge with real estate? To answer this, we need to consider two closely linked topics. First, what is an inflation hedge? Second, what makes a good inflation hedge? The first answer is simple. An inflation hedge is an asset that loses little value in periods of rising prices. Thus, it holds its value and purchasing power during inflation. This also applies to hyperinflation. An investor expecting inflation will buy this asset to hedge against inflation. ~~~~~~~~~~~~~~Special~~~~~~~~~~~~~~ When Things Get Down, Hedge Your Bets The economy has been struggling recently, and things are only getting worse. Some smart guys saw this coming and have made serious profits while everyone else struggles to stay above water. You can learn their secret strategy by simply reading this free report. Click here… ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ The answer to the second question requires understanding of the two basic types of assets: real assets and financial assets. Real assets have intrinsic value. They have value of their own. People value them for their direct or indirect usefulness. Examples include books, TVs, cars, wheat, gold, real estate, land, etc. Financial assets, on the other hand, are a claim on the income or wealth of a firm, family or the government. Their typical form is a certificate or a receipt. Examples include paper money, stocks, bonds, mortgages and ETFs. All money market and capital market instruments serve as examples. In general, real assets hedge better than paper assets. By definition, real assets have a value of their own. Inflation does not erode their value. Thus, any real asset can be an inflation hedge. It follows that real estate is also a hedge, but it’s not the best. Good hedges have a few key properties. We mention here only four. One key property of a hedge is that it holds its value. It should lose little value over time. Cars and eggs lose value over time. Land, silver and wine do not. Another key property is marketability. This means that it is easy to sell. Other people will easily take it for payment. Hence, it is good for barter. Chairs and clothes do not sell. Corn and gold do. A third key property is divisibility. This means that the asset splits into smaller parts without a loss of value. Houses, cars and cows are not divisible. Rice, wine, gas and gold are. The last key property is financing. It is vital. Experts prefer to fully ignore it. Investors buy assets with either cash or credit. Cash-based hedges are good. Credit-based hedges are bad. History repeatedly shows that assets bought on credit are prone to speculation and bubbles. The hedge might be already overvalued. In this case, investors should avoid it. Credit clearly drives real estate. Moreover, real estate recently went through a wild bubble. It is grossly expensive, so a poor hedge. The verdict is clear. Real estate is a hedge, but a poor one. It fails all of the above four tests. On the other hand, gold is a far superior hedge. Gold aces all the tests of a good hedge. That is why it is the ultimate inflation hedge. Better yet, now gold is cheap, while real estate is dear. Thus, as a hedge, gold handily beats real estate. ~~~~~~~~~~~~~~Special~~~~~~~~~~~~~~ Real Money As the dollar becomes inflated in this time of cheap money, the value and upside of precious metals becomes even more paramount. Gold has retained its intrinsic value despite the drops in our paper money. If you think the meteoric rise in gold prices has reached its peak, think again. Take a look at how far it could go… ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Real estate bought with cash, free and clear of any debt, might be a poor hedge, but it is nevertheless a hedge. It will protect the value of your money. It is not as good a hedge as gold, but it will do the job. However, we emphasize that real estate bought on credit (with a mortgage) creates substantial new risks to the investor. It’s possible to hedge one risk by assuming another, but not recommended. So what are the risks, or traps, associated with leveraged real estate? We mention here four. First, we could be wrong! What if prices actually fall — or you have what people commonly call a deflation? Deflation kills those who borrowed to hedge with real estate, because it makes those debts more difficult to pay. Even worse, deflation triggers recession, unemployment and falling income. Similarly to what happened during the Great Depression and to Japan during the 1990s, deflation results in massive foreclosures and business failures. Another trap for leveraged real estate is that the possibility of another credit crunch might spook the market. We saw this in February; we saw it again in August. Real estate was no place to hide then. The third trap concerns how investors finance real estate. An ARM, or adjustable rate mortgage, can be a risky way to finance. Rising prices drive interest rates higher. Mortgage rates may rise from modest a 3-4% to 12-15%. This actually happened during the 1970s. Thus, monthly payments could easily triple. Obvious, yet millions of Americans fell for it once again in the early 2000s. Sure, they fell driven by greed. Still, many hedgers are oblivious to this. The last trap is by far the most insidious, for it is the hardest to see. Inflation overwhelms the borrower; it eats him alive. Before long, food prices double, gas doubles, electricity doubles; prices of all the basic needs double in short order. Yet salaries do not; they lag far behind prices. Oftentimes, as in the 1970s, salaries lag many years behind. Similarly, prices of basic goods, such as food and energy, have more than doubled since 2002. Eventually, there comes the time that after paying for your basic needs, there’s not enough left to pay the mortgage. Let’s further clarify this point with an example. Say the borrower makes $2,000 — $1,000 goes to pay the mortgage; the other $1,000 goes to pay the bills. Rising food and gasoline prices squeeze the borrower. To pay the bills, he cuts down on consumption, but the bills overwhelm him — they cost him now $1,600. He got a raise and his salary is now $2,300, but he must still borrow some more, maybe on his credit cards, to pay the bills and keep up with the mortgage. He falls deeper and deeper into debt. The higher interest on the credit drains more and more of his income, leaving less for living expenses and the mortgage. Eventually, the consumer buckles. Only now it becomes apparent that he erred — he knew all along that he was paying off his mortgage with cheaper dollars, but he didn’t realize that the same cheap dollars made up his monthly salary. Even a mortgage with a fixed interest rate and fixed monthly payments did not help. Many fell for this in the 1970s, but few saw it coming. Worse, many seem to fall for this today, yet no one warns them. Forewarned is forearmed! Thus, leveraged real estate is not only a poor hedge against inflation, but also a very risky one. However, if you must hedge, then hedge with gold, not with real estate. Sincerely,
Dr. Krassimir Petrov Greg’s Endnote: Even in down times, some companies are still making money. While the Dow and the S&P might be experiencing down times, some companies are getting ready to boom, even while things look bleak. Because of market pessimism, many stocks are being severely undervalued. Check out how to identify these stocks here… Greg’s Final Endnote: Agora Entertainment’s new documentary film, I.O.U.S.A., premiered at the world famous Sundance Film Festival last weekend to very positive reviews. To learn more about this exciting and relevant documentary, click here. | 
