Thursday, July 02, 2009

The "Inflation Hedge"

Much talk has ensued in past months, around the time of quantitative easing by central banks, about the concept of real estate being a so-called "inflation hedge". What is meant by this?

The concept of "hedging" is pretty straightforward: take a position in an investment that limits the possible losses when summed with another investment. Generally one gives up some return for doing this but one can prevent against an investment being wiped out. Of course in the context of real estate, there is no hedge per se. What is meant is that real estate returns generally track inflation. Therefore if you have investments that would be hit hard if inflation increased, real estate is purported to generally increase its total return in an inflationary environment and you would at least have something, all said and done.

It helps to remember, when it comes right down to it, why real estate has any value at all. Simply, real estate is a capital asset that generates income from rents. Without that income or potential income (tangible or intangible), real estate would have no inherent value. It so happens that rents generally increase with inflation so the future value of the asset would tend to increase with inflation as well, minus depreciation of course.

The problem with blindly touting real estate as an "inflation hedge" is that the cash flows eventually determine prices. If prices are out of line with cash flows, what fundamentally justifies prices increasing with inflation? Often it is taken on blind faith that real estate prices increase with inflation as a law but prices are dependent upon the cash flows -- prices do not rise in and of themselves without cash flows rising as well. Unless there is speculation.

In a speculative bubble, where yields from cash flows are poor compared to other similar investments, it is not true that prices generally appreciate with inflation. In such an environment the balance of probabilities will have prices trail inflation at least until the underlying income streams are competitive again. You would be better off investing in real return bonds or perhaps some of the countless other investments whose income streams track inflation as well, many of which may well have better risk-adjusted returns than that condo with a 4% cap rate.

17 comments:

Etienne de Cochon said...

Thank you for an excellent post Jesse. I don't mean to be rude but could you suggest other articles for the reader to peruse or cite references to your informative post?

jesse said...

Hi Etienne, do you mean referencing general information about hedging and asset valuations, or other posts? I read a few Canadian finance blogs talking ad nauseum about inflation hedging with real estate I can put up but I'll have to search for them.

RentingSucks said...

Say you have a big pile of cash from trying to catch the market over the last 5 years or so. Is leaving it in an ING account an OK thing to do? Interest rates should rise if the inflation rate rises even if they'll lag a little bit.

jesse said...

Well I suppose an ING account is a better "inflation hedge" than a no interest chequing account. If you require capital at some uncertain time in the future, investing in any asset with a risk component to it can backfire. As long as you know the odds.

RentingSucks said...

Well before the last few years I thought I knew the odds but I'm not sure any more. Lots of crazy stuff happening. It kind of feels like play poker with a bunch of donkeys that keep getting lucky.

Trying to resist the urge to say screw it and go all-in.

first_time_buyer said...

"Well before the last few years I thought I knew the odds but I'm not sure any more. Lots of crazy stuff happening. It kind of feels like play poker with a bunch of donkeys that keep getting lucky."

Not much of a poker player but would like to add here. Its not that they are getting lucky by sheer luck. Its the house that decides to give them free money the moment I seem to be winning (infusion of liquidity, lowering of rates). The only thing that matters are votes for those stupid politicians and they dont care what the responsible crowd did, just because the majority was otherwise.

david said...

I generally agree with this post with the exception "Without that income or potential income (tangible or intangible), real estate would have no inherent value."

Just because a place can't be rented doesn't mean the place has no value. There are plenty of places for sale that have rental restrictions on them. Either the strata only allows a certain percentage of units to be rented, and that number is rented now, or the strata doesn't allow rentals at all. Those places certainly aren't free. For example MLS# V750475.

I suppose in this case you would be renting the place from yourself, as everyone needs to live somewhere.

Barry Chisholm; Mortgage and Leasing Professional said...

All good comments. I like RentingSucks "It kind of feels like play poker with a bunch of donkeys that keep getting lucky."
You're right, except they create their own 'luck'. I was an investment adviser, got out before the crash, and now I'm a mortgage broker. I also own several investment properties, so, I've seen alot of how this works and I like Jesse's stuff.

jesse said...

"Just because a place can't be rented doesn't mean the place has no value."

Hi david, I probably didn't make it clear. Rent is either a true rent or imputed. Also it is the potential future rents, not necessarily the actual rents, that would determine a property's fundamental value. Think of a single detached property surrounded by condos or an aloof millionaire's pied a terre used but 3 weeks out of the year.

RentingSucks said...

You're right, except they create their own 'luck'. I was an investment adviser, got out before the crash, and now I'm a mortgage broker. I also own several investment properties, so, I've seen alot of how this works and I like Jesse's stuff.

So what do you recommend for creating your own luck these days? Should I get the best variable rate I can get and max myself out on a mortgage. I'm just not convinced that will go so well.

RentingSucks said...

Just for an example this is what I mean by donkeys (from real estate talks):

http://www.straight.com/article-237609/firsttimers-rates

I refuse to try and compete with this but this is what is driving our house prices. Logic says it all has to collapse sometime but as first_time_buyer points out the government is actively working against having things unwind in a speedy manner.

Alan said...

OK, I'll bite. What are the other inflation hedges apart from real return bonds?

patriotz said...

What are the other inflation hedges apart from real return bonds?

Commodities, and I mean commodity producers rather than the commodities themselves since trading the latter is zero-sum.

I also want to point out that RE is a hedge against price inflation only if wages track price inflation. If they don't, RE cannot track price inflation. How optimistic are you that wages are going to track price inflation going forward?

Commodities are different because they are globally priced. The price of oil or whatever does not depend on the ability of someone in any particular city to pay for it.

Alan said...

commodity producers

Does that mean one would be investing in the stock market, with all it's volatility and irrationality?

patriotz said...

Yes.

Volatility and irrationality mean opportunities for smart people to make money.

Alan said...

Ok, I can understand making money from volatility, but only if the market is rational. I guess I am not smart enough to understand how to make money in an irrational system.

Alan said...

At least not consistently.