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Gold is a Better Inflation Hedge Than Real Estate

Commodities / Gold & Silver Feb 12, 2008 - 05:56 AM GMT

By: Dr_Krassimir_Petrov

Commodities

Best Financial Markets Analysis ArticleThe 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?


The right answer calls for knowledge of two closely-related 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 its 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. They are often called paper assets or simply paper . In essence, they are based on debt. Examples include paper money, stocks, bonds, mortgages, and ETFs. 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, real assets are all inflation hedges. It follows that real estate is also a hedge. Still, it does not follow it is the best, for all hedges are not created equal. Some assets hedge better than others. 

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 either with cash or credit. Cash-based hedges are good. Credit-based hedges are bad. As history shows time and again, assets bought on credit are prone to undue speculation and bubbles. The hedge might be already overvalued. In this case, investors should avoid it. It is clear that credit 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 passes well all tests of a good hedge. That is why it is the ultimate inflation hedge. Better yet, now gold is cheap, while real estate dear. Thus, as a hedge, gold handily beats real estate. 

One last issue concerns real estate. Buy it today, pay it later with cheaper dollars. Hundred dollars today will be worth tomorrow only fifty, may even ten. The currency debases. It is seductive; it makes people borrow; it lures; it makes sense; it is profitable. Seductive it is, yet treacherous! The investor may fall in many traps. One need fall in only one to go broke!

Let's make one thing clear. 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 your money's worth. It is not as good a hedge as gold, but will do the job. However, we emphasize that real estate bought on credit (with a mortgage) creates substantial new risks to the investor. Debt means leverage, and leverage means risks. In this sense, hedging one risk by assuming other new risks is possible, 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 that 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 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 is how the real estate is financed. An ARM, or adjustable rate mortgage, can be a risky way to finance. Rising prices drive interest rates higher. Mortgage rates may rise from 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, many years behind. Similarly, prices of basic goods, like food and energy have more than doubled since 2002. Eventually, there comes the time that once you pay for your basic needs, not enough is left to pay the mortgage. Let's further clarify this point with an example. 

Say the borrower makes two grand – one goes to pay the mortgage, the other goes to pay the bills. As the prices of food and gasoline nearly double, the borrower gets squeezed. To pay the bills, he cuts down on consumption, but the bills overwhelm him, they cost him now $1,600. He got a raise, his salary now $2,300, but he must still borrow some more, may be on his credit cards, to pay the bills and keep up with the mortgage. He falls deeper and deeper in debt. The higher interest on the credit drains more and more of his income.

Less is left for living expenses and for the mortgage. Eventually, the consumer is tapped out; he buckles. Only now it becomes apparent that he erred – he saw the cheaper dollars when he paid the mortgage, but he didn't see the cheaper dollars when he was getting paid. Even a mortgage with a fixed interest rate below 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.

Krassimir Petrov ( Krassimir_Petrov@hotmail.com ) has received his Ph. D. in economics from the Ohio State University and currently teaches Macroeconomics, International Finance, and Econometrics at the American University in Bulgaria. He is looking for a career in Dubai or the U. A. E.

Dr Krassimir Petrov Archive

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Comments

Christina Kenney
17 Feb 08, 23:59
gold mining stocks in aggressive fund Fidelity select gold

Dear Professor Krassimir...learning so much from your lectures as they are clear and concise and step by step. Is a paper stock also gold mining stocks...and also is energy o.k. and how should that be held...a hedge fund of energy...any help on this greatly appreciated...If you give a talk in the United states please let me know so I may attend your conference as so much has been confusing but you have helped me to at least have the beginning of the third eye. Sincerely Christi


Tom
26 Mar 11, 04:45
Still true

Although since this article was written, real estate has become less dear and gold moreso, it is still quite valid. The problem with real estate is that it has carrying costs. You have to pay taxes and insurance on it, maintain it, and negotiate with any renters and worry about them defaulting on their obligations. Gold suffers none of those issues.

If you want a real nuts-and-bolts, down-to-earth valuation for gold given your own individual inflation expectations, there's a cool online calculator located here:

http://passantgardant.com/gold-value-calculator

Just enter your estimated probability of various inflation rates, and this calculator will give you a fair value for gold as insurance against inflation using actuarial methods. It includes the ability to specify your own opportunity costs from holding gold instead of an interest-paying alternative. This way you can decide for yourself if gold should be a part of your inflation-hedging portfolio.


Nadeem_Walayat
26 Mar 11, 06:54
Property or Gold

Most adults can expect a 50 year lease on life.

So whats the choice ?

Live and enjoy a property or stock pile gold ?

You can't take it with you ;)

NW


Jeff Capes
26 Mar 11, 09:41
Property or Gold

Hey, that's my dilemma! Property or Gold?

At first, I chose gold - until I could afford a property outright. And then I chose property.

Because:

Provides rental income every month.

No uncertainty of 'Market Crashes' or any downturns.

Managed for me, no charts to inspect or reports to read every day.

It can't be stolen.

7.9% a year rent-property price ratio every year is a good return.


Alec
26 Mar 11, 09:50
Gold is the clear choice.

Given the choice with what we can see now, GOLD is the best choice over property. Those property owners in Japan, Arizona, SO CA, and the sinking islands of Dubai would all agree. GOLD is what you CAN take with you when you have to leave the land you live on. I am still amazed by how many folks just don't get it!


Ryan
01 May 11, 15:44
You cant eat gold!

Gold is USELeSs in modern society... You cant eat gold or live in gold... Gold will prove to be far less valuable in a worst case scenario environment. If we have natural diasters and chaos i can choose to live in my home for free... If everyone in my neighborhood decided to stop paying their mortgages at the same time... They would all own their homes free and clear when the dust settled. Sure we would have chaos... But if home prices drop another 30-40% like some are calling for then we would have chaos anyway. Unless u store gold bars under ur mattress... Try ever getting ur hands on ur hedge. I can atleast grow most all my food i need in my backyard if food prices rise...


Alec
02 May 11, 02:04
Gold Useful

When they come to your door and physically evict you for your failure to meet your contractual obligation you can just pack up your house and garden and move somewhere else down the road. Oh wait! You can't just carry your house and garden! You'll need to convert it into a smaller more easily carried yet financially stable commodity. Hmm. I know you can use US Dollars. Better yet, you can just keep those dollars in the bank where they'll be safe and continue to hold their value!

But wait! I guess this needs to be thought out a bit more.

Where can I find a commodity that is transportable and relatively stable to the USD that I can hold physical possession? Hmm...

Well I give up! After all "Gold is USELeSs in modern society... You cant eat gold or live in gold..."

But hang on... I don't want to eat or live in my gold, I just need to store and transport my wealth!

Sometimes these posts give me a headache.


Parth V.
02 May 11, 17:44
Yes you can eat Gold

In very thin sheets Indian sweets have gold.


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