Is Real Estate a Good Hedge Against Hyperinflation?
Jan 24th, 2008 | By Whiskey Contributor | Category: Macro EconomicsAS 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 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.