BFP Management Blog

Archive: June 2011

Hedging Inflation

Sometimes it is difficult to notice trends and changes when the subject is too close. Recently my son saw some photos of me from 1987 and said, “Dad you were skinny.” During the last 24 years, I hadn’t really noticed the additional 15-or-so pounds, as they were attaching themselves, nor the graying of my once totally blond hair.

The same can be said for inflation. I recently filled up my gas tank, and it cost me almost $100. I sat in my car and took out a $100 bill from my wallet and stared at it, remembering when having one of those bills bought a lot more than a tank of gas.

In 1944, the United States agreed to the dollar becoming the reserve currency for the world at the Bretton Woods Conference. The dollar would be backed by gold at a rate of $35 per ounce (a dollar was worth 1/35th of a troy ounce of gold). When the U.S. removed itself from the gold standard (direct convertibility of the U.S. dollar to gold) in 1971, the government changed the dynamic from being backed by a precious metal to a fiat currency (monetary value backed by government decree only).

Removal from the gold standard has allowed the government to print dollars and pursue policies that weaken the intrinsic value of the money (even though politicians never admit to anything but a “strong dollar policy”).

Investors who have traded their dollars into gold during the last few years have enjoyed a handsome profit. While I believe the long-term trend will up, the steep rise might well be a bubble.

Figure 1

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Source: Goldprice.org

 

I know many goldbugs who swear by and love the investment. While I agree that gold may be harder to manipulate than paper currency and has historically been a tradable currency, the investment doesn’t offer a yield while owning it.

My favorite hedge against inflation (deflating dollar) is rental real estate. The real estate itself is a tangible asset like gold and can offer a yield on the cash invested.

While there has certainly been inflation over the last few years, one asset that has been deflating is real estate. In Figure 2, we see the 20 metro areas Case-Shiller tracks. The Case Shiller indices have a base value of 100 in January 2000. So a current index value of 150 translates to a 50% appreciation rate since January 2000, for a typical home located within the metro market. Note that there are several cities on the list where houses are cheaper now than they were 11 years ago.

Figure 2

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Sources: Standard & Poor’s and Fiserv

 

I closely follow a number of the rental markets in the 20 cities listed in Figure 2 and am surprised by the seemingly low cap rates for which properties are trading. That said, with a long-term (at least 10-year) view and conservative underwriting, I believe that real estate will gain pricing power and value while the dollar won’t.

Since everyone needs a place to live, owning well located properties allows the owner to charge more, while the government continues to weaken the buying power of the dollar. Over time, this hard-asset investment should offer you a nice hedge against inflation and even more so, if the government continues printing paper.

 

 

Kyle Kazan

 

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