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.