Real Estate as an Inflation Hedge - For those who are renting.

Many of us have heard that Housing is a Hedge against inflation.  But what exactly does that mean?  In this article, we’ll examine the word Hedge, and Inflation, and then discuss this phrase, and what Macro economic factors need to be present for this to be true, and how that might apply to potential buyers out there in the market.

What Is A Hedge?

A hedge is something that helps mitigate risk. Since it’s pretty easy to explain hedging with sports gambling, I’ll use that example here. Let’s say you think the Patriots are going to win the Super Bowl this year. (They are, but that’s besides the point....). You plunk down $1000 in Atlantic City on the Pats. But you wake up tomorrow and aren’t so sure. Well, you can’t call AC and say I want my money back! But what you can do is bet $1000 for the Patriots to lose. That way, win or lose, you’ll only be out the commission for the two bets. The second bet is a hedge - a way to offset the risk of the first bet. While a hedge often costs money to execute, it’s goal is to dramatically cut your losses if things don’t work out the way you expect.

Inflation: A closer look.

Most of us understand that inflation defined as rise in prices of the things we buy. That’s not too complicated. I do think that most of us get lost when asked the next question: What causes inflation in the first place? and the one after that is tricky too: Is inflation bad? Let’s deal with the first question: What causes inflation? We understand that inflation is caused by prices going up. To see why, lets look at a company such as Oral-B, the toothbrush maker. Now, to keep this simple, I’ll be eliminating a bunch of factors, but just stay with me. 

Oral-B has a bunch of employees that make the toothbrushes. Let’s say you’re one of them! After one year, you go to Oral-B and say, “Hey, I’m much better at making toothbrushes, I’d like to make more money.” Oral-B thinks that you are good at toothbrush making, so they give you a raise. Now to pay for the raise, they need to make more money, so they push up the prices of toothbrushes, so there you go. Need more evidence that's how it works? Well the federal reserve tracks inflation, and inflation over the last 10 years has averaged about 2.4%. And raises have averaged about 2.8%. Awfully close!  Inflation has other positive aspects economically, as we’ll see, and those positives make inflation a desirable thing.

Is Inflation a Good Thing?

Is inflation a good thing? The answer, to many people’s surprise, is YES. Inflation is not only good, it is NECESSARY. Why is this so? To explain, I'll show why deflation is BAD. Deflation is when the costs of goods and services decrease over time. Simply put, that toothbrush that costs $2.00 today, will be $1.80 tomorrow. Well, if I KNOW that prices are going down, why would I buy anything today? Surely I could get another day or two out of my existing toothbrush, couldn’t I? Sure I could. And then I would save 10%. Now if you could save 10% on everything you wanted to buy this year and you just needed to wait a bit, wouldn’t you wait? You would. And that’s where the trouble starts. If EVERYBODY is not buying, but waiting, the manufactures (and retailers) have less to make and sell. With less work to do, they lay off workers. Now the workers who get laid off REALLY need to save their money, because they are out of work, so they buy even less, and wait even longer. This encourages manufactures and retailers to lay off more workers, and the cycle continues. Yikes. Deflation is really bad, I would argue the number one killer of economies, and should be avoided at all costs. Need more proof? Look at housing transactions whenever prices decline. They plummet! Why? Because most people won’t buy a house if they think it will be cheaper tomorrow. So if deflation is bad, that makes inflation good. Inflation encourages us to buy today, because tomorrow things could be more expensive. And that keeps everyone employed. That’s good. Now it’s certainly been proved that too much inflation is a bad thing.  As this post is long already, I’ll skip over why too much inflation is bad, I just wanted to acknowledge that it is.

How is Housing a Hedge Against Inflation?

Ok, back to the big question. As we noticed, in an inflationary environment, we buy today, because tomorrow, with the same money, we can buy less. And, we noted that inflation tracks very closely with compensation. The last thing we need to look at is your mortgage, and how the leverage of your home helps you make money in Real Estate. If you own a $400,000, with a $300,000 mortgage at 7% (keeping things simple here), you’re paying about $21,000 annually in interest. But what are you REALLY paying in interest? Well, your REAL interest rate is your rate MINUS the rate of inflation, let’s say 3%, so your real rate of interest is 4%, or about $12,000. If inflation accelerates, let’s say to 7%, then you really aren’t paying ANY interest at all. Confused yet? I’ll try to make it more direct. Your mortgage payment every year is fixed, assuming you don’t refinance and you’re in a 30 year loan (which we’ll assume for simplicity). Let’s say your paying $2000 a month, or $24,000/year. And you make 75,000. Next year you’ll make what? 78K? And the year after? 82K? And so on, and let’s just assume in 5 years you’re making 90K. Your home COSTS the same, but you’re making more. That's nice. And the faster inflation goes up, the more likely you’ll be making much more, making it easier and easier to stay put and pay that mortgage. Now, we all know it isn’t always that simple, but in aggregate, this is basically what happens. So even though EVERYTHING ELSE- milk, gas, toys, clothes, cars - gets more expensive with inflation, your home gets cheaper.Even more interesting, the FASTER inflation goes up, the FASTER your home gets cheaper, relative to the money your making.  That’s why it’s a hedge. Just like the hedge we described in the beginning, it has a cost, but it’s job is to offset something bad, like the cost of everything else going up. So what happens if you don’t own a home? Well, then you’re paying rent, and in an inflationary environment, rent goes up, along with everything else. So renting doesn’t protect you from inflation - only home ownership does.

There’s more to this story of course, and if you have questions, please ask them in the comments, but that’s all for now!