Is Real Estate a Good Hedge Against Hyperinflation?
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.
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 exchange traded funds. 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.
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 a modest 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
January 24, 2008
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[...] unknown wrote an interesting post today onIs Real Estate a Good Hedge Against Hyperinflation?Here’s a quick excerptIn 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 … [...]
[...] unknown wrote an interesting post today onIs Real Estate a Good Hedge Against Hyperinflation?Here’s a quick excerptLeveraged real estate is a poor hedge, especially as the upcoming hyperinflation takes its toll on the real estate market. [...]
For those who have sold their houses before the real estate bubble had burst, would purchasing real estate during the current adjusted market be a different story? For instance, houses can now be bought in my area for around $50k that were $200k just one year ago.
Additionally, assuming that the federal government will -not- be able to control its spending and borrowing, and assuming hyperinflation in the next year or two, would it not be a better idea to buy using a fixed-rate mortgage loan and pay the minimum payments? I understand that doing that is part of why there is an economic crisis, but would it be tactically smart to do? Then, assuming one does have a lot of extra cash, couldn’t that person buy gold, even though he’s sitting on a mortgage loan?
Thank you for your well written article, Dr. Petrov!
You forgot a couple further tests of the hedge: what future demand will look like, useful of the product, and transaction cost. Gold fails or rates low in these categories!. These are harder to determine but can have a huge impact on the hedge as well. For example: Oil is a physical commodity generally purchased with cash (although you could argue the speculative nature of it). The current demand is sort of week, but in the mid term the supply of oil is likely to go down and the demand to go back up (making it a better hedge in the face of inflation). The question you have to determine about Gold is whether it is going to have a higher or lower demand in the future. Much of this is tied in with usefulness.
What is Gold used for? Looking nice, expensive jewelry, and some electronic manufacturing. Silver on the other hand is used in many more industrial applications giving it higher intrinsic value then Gold whos value is tied up more with perception.
The other test is in transaction costs. Everyone knows homes and cars have high transaction costs (costs related to selling or buying the item) that detract from their value as a hedge. What most people don’t realize is that gold, silver, and many other commodities can have very high transaction costs unless you have direct access to the material which you usually don’t. Gold can have 10-15% cost difference between wholesale and retail, making it much less valuable as a hedge.
So i don’t disagree with the overall points, but you must consider more then is listed here. Gold gets touted a lot as a safe haven in inflation. Sometimes it is, sometimes it isn’t. My advice is to stick with things that people will always need, and try to lower the transaction costs as much as you can.
I disagree. In an environment where the rate of inflation is increasing, there are winners and losers. The winners are those who borrowed money and the losers are those who lent the money. Say you had 10k in cash which needed to be put into an inflation hedge of some sort.
Say that in the year 2015, you make 60k a year, and have 20k you need to invest in. You purchase a house for 300k using that 20k as a down payment. Inflation is non-existant and you get a fixed rate loan at 5 percent. You have invested the equivalent of 1/3 of a year salary. Fast forward to the year 2020. High levels of inflation have taken hold and things cost 6 times as much as before. You now make 360k a year and your house is now valued at 1.8 million. At this point in time, you would have a bit more than 1.6 million in equity in the house. Your 20k you invested 5 years ago, representing a third of a years salary, has grown to 4.4 times your yearly salary!!! If you had put that money into Gold, you would still only have a third of a years salary.
So, where did that extra money come from? Well, the massive losers in an inflationary environment are the people who loan money at too low of an interest rate. There is an invisible transfer of wealth from the lenders to the borrowers.
So, if you think that inflation will take off, best get into real estate and watch as the fool and his money is parted.
I disagree with mike. There are many assumptions in your scenario that ignore risks.
1. 360k a year earning. as the article outlines, salary can lack inflation years behind.
2. fixed loan. By the time you decide to enter a fixed loan, the fixed loan will much much higher that the variable rate, you might not really afford the fixed rate just by your salary.
3. 1.8 million is optimistic because most people is not taking fixed rate, they can not afford the interest payment, a lot of houses will be forced to sell. That would mean the prices of housing will be less that 6 times of the growth like inflation
I can easily come up with examples of showing buying real estate with mortgage is a bad hedge in a hyperinflation environment. But this will miss the point of what the author is trying to say. Real estate with mortgage may still be a hedge of hyper inflation, but it still has risks in it, much more risks than holding gold.
Good article and comments. This article was written in eary 2008, when the scope and bredth of the meldown was not known. Now it’s almost February, 2010 and gold has had a tremendous run-up in value. Commercial and Industrial real estate (at leat in NJ) has lost significant value over the past 2 years due to the economic crisis and inavailablity of financing. Therefore, quality properties can be purchased at bargain prices (if you have the cash, of course). In this environment, is not real estate a better hedge than gold, since gold prices have run-up so high?
I still think that the best hedge is with real assets that have intrinsic value. After food on the table, a house is pretty much essential. Gold on the other hand, apart form its use in jewelry, is not. What if suddenly some massive gold deposits are discoverd, does this not debase the value of gold? Sure you might have bought a house during a bubble and lost, but you could say the same thing about gold! So i’m still not convinced about gold
NICE POST. NOW LETS MAKE SOME MONEY AND GET A F….. PARTY
A woman is a good hedge against the inflation. As it is so hard to hold on to her in inflation.
Though some good points are made, I’m not convinced that gold is better than real estate as a hedge. I think it would be best to have some of both, though I prefer silver to gold.
One benefit of real estate that was not mentioned is the tax savings, something else we have to worry about with the coming tax increases
Another benefit that wasn’t mentioned is the fact that you can leverage real estate. You can’t do that with gold. When we get high inflation, the rent would increase so the loan can be paid off quickly.
This article and all comments only discuss capital preservation and growth with inflation, but failed to mention the largest advantage of real estate – INCOME. No prudent person buys rental real estate of any form and just lets it sit there. They rent it! So whether or not the capital value stays in line with inflation as good as gold or any other commodity, is only part of the equation. The real estate produces income as long as it is owned. I own several commercial buildings and many single family homes which all produce annual income of 10-15+% of thier value (after all my costs). What income does gold produce while you own it? I would rather have this income and a flat value, than value appreciation and no income, but the beauty of real estate is – you get BOTH!
What about those who are not trying to hedge, but need a place to live? Are we better off continuing to rent, or should we buy a home that will have fixed rates (and therefore payments)? I gather the danger of being unable to make monthly payments due to dollar devaluation, but what might happen with rents?
I think Real Estate that you could farm with self sustaining hydro power, some guns and some gold is best. You can’t eat gold if there are shortages of food. Hyper Inflation destroys production creating shortages. Most of everything we need is produced outside the usa. Imagine who would want to lend your nation money or provide products if the currency is worthless.
Great post. I’ve been researching hyperinflation and how it will affect real estate. My question is, once inflation has adjusted, the price of everything goes down. So if someone has a $100K mortgage, would that mortgage be cut in half since the market is adjusting?
If so and you have a rental property that you are renting for, lets say $1K/mo, and during hyperinflation you adjust the rent to $2K/mo but when the market adjust the rent goes back down to $1K/mo and your mortgage balance and payments have been cut in half, this would be a great cash flowing opportunity. What are your thought on that?
Thanks!!
Just a mention – I have about 20 apartments in 2 buildings worth about $1.3 million. While that seems like a lot of money it’s not nearly as great as it seems. With everything rented out the net income is pretty good but the TIME spent in keeping them up is an important factor. What with upgrades, repairs and maintenance these 2 buildings take up plenty of personal time. If you hire these things out you can easily go into the red each month.
I am hoping there are a good income source / inflation hedge but am paying a price in lifestyle.
t
This article is quite innaccurate and incomplete. Actually, while it provides some basic characteristics of what a good hedge may include, the accuracy of its analysis on Real Estate and Gold markets is wrong. First, hard commodities are usually a good hedge, though are still supseptible to global market supply and demand, and if the US enters a period of hyperinflation, consumer markets will suffer and so will the global demands for commodities, but relatively, you can store some value here. In regards to real estate, he is absolutely wrong in his analysis of utilizing debt during inflationary periods. Actually, fixed debt is awesome! If i have a fixed mortgage on a piece of property, as inflation occurs i am paying the mortgage company a fixed obligation. Our labor is a factor of production, it increases in cost to the producers, same as commodity costs. So as an example, say a loaf of bread goes up from $1 to $10. Why, because the dollars value has decreased by 90% and in real terms. So it takes you $10 inflated dollars to buy a loaf of bread, and the producer has to pay inflated costs of inputs (grain, yeast, labor (you), etc). In regards to the fixed mortgage, you are paying this back on a fixed basis, your $200,000 mortgage real value is now only $20,000 or 1/10th. In real terms, the bank is in trouble, and the debtor is golden. So holding debt which is not adjusted for inflation is a great thing and is used by investors to make lots of money during times of inflation. There are many other attributes to owning quality real estate during times of inflation, i urge people to look beyond this article and do some research.
A paid-off house with plenty of energy-saving modifications and a veggie garden/chickens can change to a multi-generational dwelling during hyper-inflation. To me it seems to be the core plan of a hyper-inflation strategy. Just the shared car would make it worth it.
NOBODY should have a large mortgage anymore. Hyperinflation or no, jobs are just too insecure and hard to come by. I would rather the kids be used to living with grandma and their cousins and if we have too much money, then we’ll take more vacations.
Why do you smarter than I folks always talk as tho houses and rentals are the only Real Estate. Farm land can be purchased and leased to a neighbor farmer. It is easier to eat the product that is produced on farm land and the demand will always be there. You city folk should know where all the Heavyweights are putting their big dollars right now. Check Montana Land and see what has happened in the last few years since Mr. Ted Turner and others have hedged their money there. Just a thought…..
Gold produces very little income when leased out real estate produces income. Hands down real estate destroys golds. Your not comparing apples to apples. If you leased or borrowed or leveraged gold it would be just as risky as real estate!!! Gold does nothing more then real estate they are both commodities just like corn or sugar or oil they are tangible hard assets. A well picked real estate investment that produces income that you pay cash for totally destroys gold on a ROI type basis over the long haul. I will compare my duplex I paid cash for 30 years ago against your gold you paid 350 an ounce for 30 years ago any day of the week hands down I win. In 30 years your gold went from 350 an ounce to 1500 an ounce. My duplex went from 50k to 170k and thats after the crash in the market. My duplex also produced income after expenses in the range of 700 per month for 30 years the actual rent per apt was about 650 per apt but expenses eat up some so we will say after management fees and taxes and ect 700 per month from the 1100 i get in rents. 700×320 months = I will use 550 for rent amount per apt since rent where lower 30 years ago…
700 bucks x320 months = 224,000 in rents 170k in value= 394,000… Your 350 dollar gold shoots up to 1500 per ounce and now we sit with 50,000 in gold being worth a little more then 225,000 in gold you have.
I wont argue the particulars that gold is in a bull market and may go higher it could be just as real estate is in the trough of a bear market and is in the opposite situation how ever . The astute investor already understand the power of leverage and its destructive qualities as well. So telling the public dont buy real estate because of the risk of borrowing is assuming we need to borrow. Investors have cash they dont always need to borrow just like those that bought gold maybe they paid cash? Remember gold and silver while shiny and iron clad have the distinct problem of not generating income all it is is a way to hold income a safe haven to hold cash that you need to have access to quickly. If you are not in a hurry to liquidate real estate is far better an asset since it produces. How ever if you cannot actively babysit your assets then maybe gold has the edge or silver. These assets have there place and I like gold and silver and I tell people they should have some but the majority of assets need to produce income or its not doing its job. Capital needs to produce. Leasing gold could make your 50k grow a ,little bit but you lose the control over the gold as you give it to a 3rd party that the risk is they dont return it if the market crashes so I cant really give you that when comparing gold to real estate. My well placed duplex appreciated modestly as did the rents and I could liquidate today for 170k in less then 30 days. The recent appraised value is 225k so I figure knock off at least 20% in this bear market. I just bought a few more distressed properties as income producers and I sold off gold and silver that exploded in value leaving too much of my portfolio in what I consider non producing assets. I like gold but I dont need 20% of my assets in gold and silver… So I bought 2 more duplexes that will produce 2k a month after expenses and management. What is left in gold and silver will stay there to protect my cash position in the market place.
For years I have owned some single family dwellings in California and prior to the R.E. bubble popping I borrowed on them and put the money backing into them by upgrading them and the landscape. My thought was that they would provide steady income in my retirement which has now arrived. Values on my properties are roughly 50% what they were, but rents have held firm.
Despite the advice of so many economic forecast authors I just can’t bring myself to selling them. I believe even if their values further decrease during a major economic meltdown, i would still have rental income. That is enough to pay their mortgages (all fixed rate) and supplement my wife’s and my pensions. So, even with rent controls, we would be able to survive the meltdown. The worry I have is whether or not current rental values would be drastically reduced during very hard economic times with hyperinflation.
Anyone know what rents were like in the hyperinflationary Weimer Republic of Germany? I have read that R.E. values were down, but what about rents? Anyone have any thoughts on this?
Rents would come down but food would go up a lot. I have learnt 2 gurus recommend buy and flip not buy and hold due to potential of reduced rents and higher tax, maintenance, and insurance during hyperinflation. Please do some more research and let us know.
It’s real simple…there is a finite amount of land. The population is growing…and however you want to believe the earth is warming so the amount of land available is shrinking. Supply and demand. Do the math(s.)
Cali James – I agree food would go up a lot, but I think rents would go up to. Demand for rental properties will increase since people will not be able to afford to pay their mortgages in a hyperinflation scenario. Remember, salaries will drag behind the real cost of goods. This will force those who can barely afford their mortgage now, to seek a rental.
The author of this blog is ill-informed. Real estate is a far better hedge than gold for several reasons, especially in this current environment
1) Intrinsic Value: people need places to live in, thus real estate has excellent intrinsic value. Gold, on the other hand, has no real value except for being a traditional medium of exchange, primarily due to it’s aesthetic appeal, rarity, and divisibility. Can you eat gold? No. Can you live in gold? Not really. Does gold have industrial purposes? Yes, but they’re fairly limited.
2) Housing prices are down; gold prices are up. Now is the perfect time to buy real estate because prices are low! Sure, they may go lower, but they can’t go much lower from here. Gold prices, on the other hand, are very high. Sure, the price of gold may go up even more, but at these levels it’s far more risky to own than real estate (what if, by some miracle, a hyper-inflationary scenario doesn’t play out? people will still need homes to live in, yet gold will undergo a fire-sale)
3) You can get a low interest rate fixed mortgage. That’s right, if a hyper inflationary scenario were to occur, your returns would be leveraged because your house would be bought with borrowed money…borrowed at a very, very low interest rate (for those who don’t know, rates will increase considerably if inflation unfolds). Say for instance you buy $200,000 home with a $50,000 down payment and a $150,000 30 year fixed mortgage. If the dollar loses it’s value by half, your home value would double to $400,000; however, you would still only owe $150,000; that means your home equity is over $250,000 now! Your initial down payment of 50k would experience a 500% percent return!
And the best part is that say if such a scenario doesn’t happen, you still bought a house in a buyers’ market when rates are low! The downside risk is limited while the upside is similar to buying gold. Did I mention you can live in your house (unlike gold) and you wouldn’t be paying rent, but a mortgage instead (adding to your home equity)
For those with large sums of wealth, considering gold may be an option, but for the average person, owning a home is a good deal if you can afford it!