Why is Real Estate a hedge against Inflation???

Well cost to rent is part of the cpi. So if CPI goes up, rents go up, therefore laggingly increasing the value of property?

Inflation is great if you have a mortgage...your payments remain fixed.

Real estate is a hedge againt inflation as long as your taxes and maintenance do not grow by more than inflation. The reason for that is that rents are expected to go up at the cost of inflation over time (even though it has not been the case in NYC in the last ten years), but your mortgage is fixed.

what is meant by "inflation"? You can have flat or diminishing home value and the cost of utilities, consumer products can increase.

If you have inflation and your home value goes down though, thats really not good.

real estate is a hedge against inflation when the following occur:

1) there was no bubble in credit prior to the inflationary episode; social attitude towards borrowing
2) there was no bubble in housing prior to the inflationary episode; social attitude towards housing
3) when credit is marked to market and rising - i.e. strong banks, well capitalized, deep lending capacity
4) when economy is overheating and wages are rising
5) when unemployment is below 6%

Unless the following items occur, how can we expect housing to really fly with high inflation? Otherwise, the cost of lending and the rising cost of stuff we need to live will crimp consumer wallets and shrink corporate profit margins. That is why this time IS in fact different. Look at where we are coming from!! The pain is DEEP!

Cash is definitely not a hedge against inflation, and neither is owning the long T-bond.

So you are left with a couple of choices, Stocks, Real Estate & Commodities.
Problem with equities is dividends are taxed, and companies may not be able to pass along cost increases especially in a situation with weak employment and rising prices(stagflation). Commodities should do well, and Real Estate is forecast to do only match inflation or exceed it by at most 1%.

Sounds like Real Estate and Commodities are the two best options. An asset that maintains its value against inflation sounds pretty good. And Real estate has a better cost of carry than commodities which may do better, but pays no interest.

Real estate is a hedge for a couple of reasons.
1) limited amount of land
2) increased prices raises replacement cost.
3) increased population creates more demand

The combination of the three help underpin prices.

the problem with the hedge against inflation argument, is in the definition. I recall when my old trading buddies bought gold in early 2008 because of inflationary concerns, because the dollar would collapse. I told my side of the story. In the end, 2008 was deflationary, the dollar rallied, and gold still rose. So to them, they were right and had the right asset class!

Excellent point!! before you can decide on what hedge is most appropriate you must define the risk. There are so many forms of inflation. I would counter that if one is thinking long term or even multi-generational something not unreasonable when speaking of real estate, we need to back away from current events. In five , ten or more years from now the current economic environment will have little importance and who can really predict what will happen seven years from now. Meteorologists seem to have difficulty with 24 hours.

Ummmm, HELLO, TIPS and muni and corporate bonds tied to inflation or EXACT hedges for inflation. As are inflation swaps.

Over the past 20 or 50 or 100 years gold has not only been a terrible investment, but a terrible inflation hedge. There have actually only been a few periods when it has NOT been terrible. It IS, however, a way to lower the overall volatility of your portfolio as it tends to have a low or even negative correlation with other asset classes.

Commodities as whole can be a hedge.

Housing should not be used as an investment tool by anyone serious. For most of the past 110 year, housing has moved in-line with inflation, not counter to it (which is what a hedge is.) For proof, see Case-schiller's 1890-2010 national home price chart or table:

http://www.multpl.com/case-shiller-home-price-index-inflation-adjusted/

http://www.multpl.com/case-shiller-home-price-index-inflation-adjusted/table

Only a complete moron would look at that and say housing is an inflation hedge.

BTW, their data for NYC shows a similar pattern since 1890, and the Dutch have housing records back to the 17th century, and guess what? Same pattern. Nominal home prices go up, over time, in line with nominal GDP at most, and with inflation-adjusted are basically flat.

It is a hedge against inflation, but not a hedge against high interest rates.

TIPS are not a hedge against inflation.
Unless you happen to believe, and nobody really does that the CPI accurately measures it. It actually understates it quite a bit. Prior to 1982 I might have agreed with you.. that is if TIPS existed.

Another idiotic comment.

And over the last 50 years we saw inflation rise and come down. Gold has actually risen quite a bit from it's low of $350, so its done quite well if measured from trough. What's gold now $1200+?

I'd there any content to what you say? Ever.?

So wait, lets apply this to what may matter to us, to buy a co-op/condo. If an apt is priced @ $600,000 now, if inflation rises 10% the next two years, hence 30 year conforming mortgage rate pops up to 8%, will this same apt be priced higher or lower than $600,000? Logically it can't be higher due to the fact of higher carrying costs including maintenance. Right or Wrong?

depends if we have wage inflation. in the next few years, probably not. five years from now, maybe...

Big question is whether the Treasury and Fed monetize the debt.

You don't need stocks, you don't need bonds, you don't need gold, but you need a place to live. Real estate wins because it is REAL, and most other investments are subject to outside forces that can make them essentially worthless, i.e. Lehman bonds, General Motors stock and bonds, promises from Bernie Madoff, etc. At least you have a roof over your head with your real estate investment, and it will likely be better than the one that Bernie has over his head now.

Well spoken. Bravo!

More good=> more real stuff. WTF?

More gold => more reality. Flmaozzzzz

What is CC's problem? Nothing to counter, just name-calling? Weird.

Hofo, suppose that long-term risk-free interest rates are at 4%, and that long-term inflation expectations (which can be measured from TIPS) are at 2%.  Effectively, the world demands a 2% real yield on top of inflation.

Say there's some piece of housing that rents for 4% of price, and there are 2% associated costs.  The net yield is 2%, but this yield increases with inflation by 2% a year.  This has the same value as adding 2% to the initial yield and keeping it fixed, so effectively a 4% fixed yield.

In the above scenarios, the world has decided that there should be no premium yielded by RE over risk-free long-term rates (screwy, but the picture in many instances).  Suppose this is held constant, and long-term inflation expectation double from 2% to 4%, and nothing else changes.  What happens?

Well, the risk-free rates still want inflation-plus-2%, so 6%.  The home now yield 2% upfront, now increasing at 4% a year, yielding an effective 6% fixed.  This is a zero spread over risk-free rates at it was before, so all is at it were previously.  Even with no price change, the same effects hold.

This is why it is inflation-hedged: changes to inflation expectations do not affect price.  Now it is true that in one scenario, the home value and rental value appreciate at 2% a year vs. 4% a year in the other in nominal terms, but this is fake: inflation-adjusted it all remains flat.

All that said, buying a home is often accompanied by a long-term fixed-rate loan (sometimes it's not: ARMs or cash purchases).  It is absolutely the case that if you lend money at a fixed rate, and the rates go up (one source of this being inflation expectations), the value of your loan goes down.  The lender loses, so the borrower wins.  Now, it is not at all required to buy a home to make this sort of trade (you can simply short bond futures), but many people think this is part-and-parcel with RE investment.

Having lived through and bought real estate during the early 80's, my experience is that as interest rates rose, real estate values tumbled. Normal people, even with cost of living increases, could not afford to pay 18% interest rates on high priced homes. Something had to give. Since they had to pay the bank so much for the use of the money, they could not afford high prices on homes. The nut to the buyer was the same, it was just the way it was broken up. I'm sure someone else can explain this more eloquently. As interest rates came down, property prices increased. So if you actually were able to buy when interest rates were high and property values were lower you could refinance the mortgage as rates came down, thus lowering your monthly payments. Your home was also now increasing in value because you bought when the market was low. At least that is what happened for a lot of us during that time. Does that make real estate a hedge against inflation?

but according to brokers, lower interest rates make housing prices rise and higher interest rates (high inflation) make housing prices rise too. So, it must be a good time to buy in both? Commission please.

PS: People need to understand that it is entirely possible that we will see a move higher in treasury yields that is not necessarily a function of high inflation. Sounds weird yes, but it compliments the 'dollar could rise and gold could rise too' call from long ago. Given the extreme policies and extreme engineering by the fed, you could see a big rise in treasury yields that are more a function of unintended consequences of a fed engineered carry trade, and less a function of rising wage inflation amidst a overheating US economy. Watch out for this.

This is an academic argument. Of course there are real world reasons why real estate would not appreciate if inflation picks up. If you think it is currently overvalued, future credit availability, etc. Having said all that, under normal conditions, if you anticipated future increases in inflation, what would you do? I would buy a levered asset by borrowing in today's cheap dollars, and pay back that debt using future inflated dollars. Rental income from that levered asset would be expected to increase with inflation, while your debt payments would be fixed. That is why people say that real estate is a good hedge for inflation. Of course it doesn't have to happen that way, but open a text book, and that is what it will say.

Couple of points.

1)It's not nominal rates that matter, so if hypothetically inflation were running at 3% and mortgage rates were at that same level you are effectively borrowing at 0%.
2) The market is not focusing enough on the risk that Fed & Treasury monetize the debt. There are billions of dollars of questionable GSE mortgage debt on the Fed's books and considering the delinquencies and receivership status of the GSE'S and Congress's reluctance to authorize funding this is something that clearly must be considered and is potentially very inflationary.

http://www.hussmanfunds.com/wmc/wmc100809.htm

Jhochle, the asset is not the thing making you the money (it is hedged). Rather, it is the borrowing at a fixed rate that makes the money. The asset is entirely ancilliary, academically speaking of course.

inonada:
Can you help us understand how you measure the inflation in TIPS?

For example what if I look at 30-year treasuries at 3.55% and I compare to the 2.125% TIP maturing 2040, which is currently yielding 1.58%?

Are you comparing the 3.55% to the 1.58%, to say TIPS are pricing in 1.97% inflation expectation, call it 2% rounded? Or is it something more complicated than that? TIA.

Treasury yield less TIPS yield of same maturity...

Yep, seg, that's pretty much it: the market is willing to trade CPI at 2% a year over a 30-year horizon, long or short.

If you want to get fancier, there are some complications I know about. First is that the people who are short inflation typically want to be paid some sort of premium for taking the higher-risk side of the trade. I.e., their inflation expectation might be 1.5%, and they want 0.5% of extra juice to cover the risk of inflation spiking. The long side might also expect 1.5%, and they're willing to pay the extra 0.5% as insurance. Second, I think TIPS not only inflation-protected, but they also benefit in deflation compared to something that fully tracks inflation. I don't remember the exact story, but while an increase in CPI yields more money for TIPS, a negative CPI does not cost TIPS money because of how the coupons are defined (they cannot be negative). This means there's some sort of embedded option in TIPS. Third, and most importantly, markets can be fantastically wrong about the reasonable price of things compared to any fundamentals because of bubbles: e.g., stock market in 2000, RE in 2007, etc. Now I'm not saying any such thing is going on in this market, but if there were, then readings of future inflation expectations from it could be skewed.

Inonada...Thanks again. You have the rare ability to explain complex concepts ( at least complex to me)

I'm sure you could build a forward curve for the market term structure of CPI using TIPS of various maturities. This could be useful if you chose to bet above or below the TIPS market implied inflation rate.

COMMERCIAL real estate is a good hedge against inflation NOT RESIDENTIAL. Commercial real estate lease rates are pegged to inflation so the commerical owner gets constant increases. Does not apply to residential.

^^ That is somewhat true, yes. In the short term. Longer term, no.

Your best bet if you believe any of this is to buy a basket of REITS or a real-estate ETF or a derivative of the Case-shiller or other index, NOT a home. YOUR home may go up or down in value for purely local reasons - even reasons having to do with JUST your particular block.

Investing in a multi-family dwelling in Washington Hights, Jackson Heights, LIC etc. Someplace where the residents can afford to pay but not afford to buy and move out. You alos get the diversification of not being exposed to a single tenant.

I would rather own a REIT or real estate ETF much more broadly reflective of the national market, or even international market. Its also much more liquid and less of a hassel.

> Real estate is a hedge for a couple of reasons.
> 1) limited amount of land
> 2) increased prices raises replacement cost.
> 3) increased population creates more demand
> The combination of the three help underpin prices.

Thats not what a hedge means.

Btw, you could also apply all of those things to ... water.

Even more so, because you can't really share water as much as you can share a bedroom.

"I would buy a levered asset by borrowing in today's cheap dollars, and pay back that debt using future inflated dollars."

Why not do that with stocks then?

"Rental income from that levered asset would be expected to increase with inflation, while your debt payments would be fixed."

With stocks, same things would happen with dividends, no?

"That is why people say that real estate is a good hedge for inflation."

There are many different reasons people make mistakes. Knowing only a fraction of the full story is a frequent one, and one big reason this mistake is made with RE.

Its hard assets that often get noted as inflation hedges.... but there are many sorts of hard assets. Many fit the bill much more than RE.

Housing costs are a big part of the CPI. An asset that generates rental income over time would be attractive if one expects those costs to accelerate.

Except if the cost of the asset far outweighs the rental income.... which is the case with the buy/rent ratios we've seen for quite some time.

I agree this doesn't work short term.

Why not do that with stocks then?

2 reasons - 1st, the earnings of the companies might not be able to keep up with inflation. 2nd, no margin calls on a mortgage - so you can be wrong before you are right and still win - not necessarily the case with margined equities.

Companies cook the books, and you have business models to worry about, etc, corporate profits ,etc. There are lots of problems using stocks. No slam dunk here.

"COMMERCIAL real estate is a good hedge against inflation NOT RESIDENTIAL. Commercial real estate lease rates are pegged to inflation so the commerical owner gets constant increases. Does not apply to residential."

?? Of course it applies to residential same as commercial. Every residential (and commercial) lease I ever saw had 1 year $XXXX,and then... if 2 years + X.X %. Not only that.....residential rent is part of the CPI, not only that.....the more housing costs to rent, the higher income that place generates....not only that, the more income it generates the higher the value for that property and laggingly, the more ownership of a home as a competitive housing source goes up.

Riversider:

"TIPS are not a hedge against inflation.
Unless you happen to believe, and nobody really does that the CPI accurately measures it. It actually understates it quite a bit. Prior to 1982 I might have agreed with you.. that is if TIPS existed."

Riversider:

"Housing costs are a big part of the CPI. An asset that generates rental income over time would be attractive if one expects those costs to accelerate."

Since you cannot even agree with yourself what defines the 'inflation' we are trying to hedge against, I will pretty much ignore anything else you have to say on the topic. And yes MOST people in fact do believe the CPI is the accurate, be it unions setting COLA increases, businesses making investment decisions, or traders on Wall Street reacting to the latest inflation numbers.

"I'm sure you could build a forward curve for the market term structure of CPI using TIPS of various maturities. This could be useful if you chose to bet above or below the TIPS market implied inflation."

The Treasury (if you believe their propoganda, RS) has the daily data on their website:

Subtract this:

http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/real_yield.shtml

From this:

http://www.treas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml

Enjoy.

"Why not do that with stocks then?

2 reasons - 1st, the earnings of the companies might not be able to keep up with inflation. 2nd, no margin calls on a mortgage - so you can be wrong before you are right and still win - not necessarily the case with margined equities."

On your first point, Shiller has data on this stuff on his website. Inflation 1871-2010 averaged 2.1%. Earnings growth averaged 3.7%. Dividend growth averaged 3.3%. Two World Wars, the Great Depression, numerous financial panics, long bouts of deflation, long bouts of inflation, long bouts of stagnation. Earnings growth tends to track inflation + real productivity growth long-term, just as rent & home price growth tend to track inflation.

On your second point, I believe there are companies offering products whereby you promise to pay, say, $10K a year over the next 5 years, and they buy $50K of stock for you today. For a fee, of course. Not saying it's a good idea, just saying it's there.

"I'm sure you could build a forward curve for the market term structure of CPI using TIPS of various maturities. This could be useful if you chose to bet above or below the TIPS market implied inflation."

The Treasury (if you believe their propoganda, RS) has the daily data on their website:

Subtract this:

http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/real_yield.shtml

From this:

http://www.treas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml

Enjoy.

Forward curves involve boot strapping.. but nice over-simplification.

Riversider:

"TIPS are not a hedge against inflation.
Unless you happen to believe, and nobody really does that the CPI accurately measures it. It actually understates it quite a bit. Prior to 1982 I might have agreed with you.. that is if TIPS existed."

Riversider:

"Housing costs are a big part of the CPI. An asset that generates rental income over time would be attractive if one expects those costs to accelerate."

Since you cannot even agree with yourself what defines the 'inflation' we are trying to hedge against, I will pretty much ignore anything else you have to say on the topic. And yes MOST people in fact do believe the CPI is the accurate, be it unions setting COLA increases, businesses making investment decisions, or traders on Wall Street reacting to the latest inflation numbers.

-----------
Of course I can. There's little conflict. The CPI is a terrible measurement of inflation. However if one were to look to an asset that delivers income competitive with one of its larger components than owning a housing asset that generates rents makes sense.

OR...or...you could just buy inflation swaps, which I said 40 posts ago.

Stocks do best when rates decline. Highly correlated with interest rates. It's not clear to me the are the best inflation strategy. Better than bonds yes, but against other assets, I need to hear more on the topic. For now I'm more in the commodity camp, which I for the type of inflation I expect will be the best choice. Real estate probably just holds it's own.

OR...or...you could just buy inflation swaps, which I said 40 posts ago.
if they are based on the CPI I don't think they will deliver the returns I'm interested in.
and on a separate point, not looking for counter-party exposure(if there is none, then ignore the comment)