
With inflation still raging on and the Fed signalling that it will indeed take action against it soon, many wonder: What can I invest in to offset its effects? Stocks and bonds aren’t perfect solutions, but two answers are currently the most popular: Commodities and real estate. I won’t get into commodities in this article, but instead focus on the latter. Real estate is pretty expensive right now but mortgages are still low, so buying shouldn’t be too much of a problem, right? Also, why is real estate considered a good inflation hedge? And is it really a hedge at all?
Inflation
So, as a quick recap: Inflation is the reduction of purchasing power in money over time and it happens when money is made more readily available in the economy. This can happen by printing money or artificially stimulating the economy. In this case, the latter happened. When the Coronavirus pandemic hit in 2020, the production of many goods was stopped and the economy as a whole was halted. Normally, this would mean complete chaos for the people, but central banks stepped in and stimulated the economy. The problem with this, is that bond yields were already really low and stocks sky high, signs of an already stimulated economy. This new stimulation resulted in the people still having a lot of money to buy goods and to pay for services with. So, when the economy was partially reopened in 2021, people expected to see the same number of products and services that were bought and sold before the pandemic because they had the money to pay for them. The factories took a hiatus in 2020, though and it wasn’t possible to satisfy the people’s needs that quickly. The basic economic rule is: When demand is higher than supply, prices rise. And when they rose, they rose high. The Fed obviously noticed this development and planned measures to combat it. Meanwhile, however, many people started to wonder: what can I do stop inflation from eating away at my money?
A few options are available: Stocks? They have been stagnating ever since the Fed announced they would rase rates. Bonds? After years of bond buying programs and low interest rates, prices are just too high and yields are too low right now. TIPS might be an option, but only in special circumstances. Then, there’s real estate.
Real estate and its benefits during inflation
Real estate refers to an area of land along with any improvements or changes made on it, such as buildings. So why do people think of real estate as a hedge against inflation? Well, there are a couple of factors. Home prices tend to rise over time as the population increases and cities expand. This is why the most expensive homes are in the city centre while the less expensive ones are on the outskirts of the city (Also, the city centre is THE place to be and the saying is: Location, location, location). There is a general measure of safety, though. If you buy properties that are cheap, they are more likely to rise than properties that are already sky-high and don’t have that much room for growth. They act like stocks in that regard: when you buy a well-established firm like Google, there’s going to be a lot less room to grow than with a small firm that has a lot of innovation and growth potential. This rise over time can also move with inflation or at the very least offset its effects a bit.
Next, if you want to buy real estate, mortgage rates are lower than ever. This becomes even more advantageous when you realise that the mortgage payments you pay (provided they are fixed-rate) are always the same amount. This means they become less valuable to the lender over time. It also means that you have to pay less. In other words: the equity of the property increases, whilst you pay less as time goes on.
Finally, real estate offers a very flexible way to deal with inflation: rent. When you don’t sell your property, but rather decide to rent it out, you can increase it at your leisure. Of course, this doesn’t mean that you can charge anyone an infinite amount, because you still need actual tenants that can afford the rent that you demand. It just means that the rent can be adjusted with the inflation index. All of this makes real estate sound like an awesome investment. But is there a catch?
Problems with real estate
First of all, you need to consider the risk of a real estate bubble. Even though mortgages are very low right now, making it pretty easy to buy a home, the prices are extremely high. Note that this also depends a lot on where the property is situated. If you can manage to find a property in an area where prices are low and where you expect them to go up, go for it. But if you really want to profit from rising prices in real estate, that is already expensive, due to high inflation, you must ask yourself: How much can this actually go up before people will stop buying? Especially now, when prices are rising rapidly, the risk of a bubble is high. If you want evidence, I would refer to you the housing bubble that popped during the 2008 financial crisis. The conditions were a bit different, since you could lend money a lot easier back then (even with no money down!). However, market conditions are pretty frightening right now. The truth is that we are dealing with a seller’s market. It is better to sell real estate that you’ve held for some time than to invest in a property right now. Since the financial crisis, prices have been on the rise and it’s looking like the real estate boom is going to slow down soon. That doesn’t necessarily mean that there will be a crash, but a stagnation of the market is pretty likely.
But, what about the low mortgages? Bond yields are the main reason for those. For more than a decade, the economy has been going through a stimulus, causing bond yields to drop. Mortgage rates move with the state of the economy and the riskier the economy, the higher the mortgage rate to compensate. It is more than feasible that mortgage rates will rise soon, since bonds yields are on the rise as well. So, should you quickly invest in a bargain deal now? Well, not so fast. Taking into account what I said above, it seems that investing in real estate right now is taking an unnecessary risk. High prices that are bound to stop rising soon should be enough to deter you from buying. This, of course, makes real estate unfit as an inflation hedge as of now.
Furthermore, another problem with real estate is that you cannot act quickly with it. It is pretty illiquid. While you can trade some stocks in mere minutes, trading real estate can take months – remember: you need to find an actual buyer with a decent amount of money, who likes the property. If prices rapidly drop, you will struggle to find a buyer even more than you normally would, because many do not want to buy in a bear market.
This problem can be solved with Real estate investment trusts (or REITS), which are designed for people lacking the necessary funds to buy real estate themselves. They are essentially Funds, like ETFs but for real estate. You would now have a liquid source of income from real estate, which even pays you a lot of dividends. Actually, they are required to pay you 90% of their income as taxable dividends. This still doesn’t solve the problems I’ve mentioned above, but you might give them a shot, if you could get them on a bargain basis.
Conclusion
Real estate would have been a great investment about a decade ago, after the financial crisis of 2008, when prices still had a lot of room to grow or a couple of years ago, when prices were higher, but mortgages were very low. Now, though, prices don’t have a lot of room to grow and while mortgages are lower than ever, it just doesn’t seem worth the risk, seeing as a bubble burst / stagnation might be around the corner. Real estate would be a great inflation hedge if prices could rise forever. Unfortunately, that’s not how the economy works and the notion that real estate should be used as a hedge in order to open oneself up to unnecessary risk is absurd. Note that there is an exception to this: Properties with low prices. If you manage to find a market somewhere with low real estate prices, that has room to grow in, at least, the next 5 years, you could actually scrutinise the properties further and assess if they are indeed worth buying.
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