Financial Mathematics Text

Sunday, June 15, 2014

Real Estate: The Better Inflation Hedge

In my previous post, I discussed having a healthy dose of skepticism when one sees a correlation between two variables. The relationship may not hold very well out of sample (such as future performance).

But I also discussed gold as an inflation hedge and I suggested that gold was a lousy inflation hedge in spite of what most people seem to believe.

Today I want to discuss another asset class which, although may or may not be a good inflation hedge, is nonetheless a better inflation hedge than gold. Furthermore, this asset class has many other attractive features that suggest it should be pursued before gold if you're looking for a hedge against inflation.

Real Estate and Inflation

So today I want to look at real estate as an inflation hedge. In my previous discussion by looking at how well gold correlated with inflation by looking at a 5 year rolling correlation. We'll do the same here.

Here's what gold looked like:

Obviously there were substantial periods in which gold was poorly correlated with CPI.

So how does real estate look?

First, I began by looking at Robert Shiller's data, in particular the Case-Shiller Housing index.

With the exception of two periods, there's definitely a good correlation (at least better than gold.)

Another asset class we can look at is the REIT (real estate investment trust) asset class. For this I used Wilshire's REIT Total Return index and again looked at 5 year correlations with CPI.

The fit is not as good as housing but still better than gold. The point here is that if you're looking for an inflation hedge, real estate (either housing or REITs) is a better inflation hedge than gold, as far as correlations go.

More on REITs and Inflation

So are there tangible factors that allow REITs to benefit (or be harmed) by inflation? 

In his book, Investing in REITs: Real Estate Investment Trusts, Ralph Block discusses the role inflation has on REITs. He points out that, while inflation is one factor that affects REITs, there are multiple other factors that have an effect as well. Let me summarize some of the ways Block claims inflation can affect REITs.

Inflation Increases Value of REITs
  • Inflation can boost the replacement cost of real estate (higher replacement cost means it will cost more to build new, equivalent properties.)
  • Higher wages can lead to higher rents (for residual property) and higher retail sales (some retail real estate contracts have a sales clause in them that allows them to collect a percentage of sales.)
Inflation Decreases Value of REITs
  • Inflation can increase costs such as property taxes, insurance, maintenance expenses, management fees, etc.
  • The Fed may respond to inflation by raising interest rates, thus increasing borrowing costs as well as Cap rates for real estate investment.
A depressed real estate market, Block notes, can result in real estate selling below its replacement cost for long periods of time. As a result, while there are many ways in which real estate can benefit from inflation, the benefits cannot be outpaced by the costs that inflation brings.

REITs, a better choice than gold?

So apart from correlations, there are plenty of other reasons to prefer REITs to gold as investment vehicles.1

For example we can look at historical returns of both asset classes (both in real and nominal terms.) I've chosen the period from 1978 to 2014 (the REIT data doesn't go back before 1978) and looked at the annual returns of both REITs and gold. Here are some summary stats: 

In both real and nominal terms, REITs outperformed gold over this historical period. REITs were also far less volatile than the shiny metal. About the only variable in which gold outperforms is their best and worst year, however, gold still underperforms when looking at drawdown.

Is there any point to hold gold?

So much of this article has been praising REITs over gold as a better inflation hedge. There is one reason to consider adding gold to one's portfolio: correlations.

When you add assets that have a low correlation with your other assets, you can reduce the volatility of your portfolio. This has the potential to also increase your CAGR.2

Here's a look at 5 year rolling correlation between REITs, gold and stocks (using the Wilshire 5000 total return index.)

As you can see, gold consistently has a lower correlation, often going negative. This would suggest that there may be value to adding gold to your portfolio with the caveat that gold is not an investment (see my first footnote for explanation.)

In Summary

I'll keep this short and sweet (since this post was long enough.) Real estate is better correlated with inflation than gold is so it's a better inflation hedge though not perfect. There may be other reasons to hold gold since gold allows for diversification by choosing an asset that is less correlated with stocks than real estate.

1 As a matter of technicality, I don't think of "gold" as an investment. Typically when people talk about "investing" in gold they mean they're going to buy some gold and stick it on a shelf or in a safe somewhere. That's not very productive. The same can be done with real estate with lousy results. For example, if you buy real estate you'll have to pay property taxes as well as various maintenance expenses. To make real estate an investment one has to do somethng productive with it such as leasing the land out or building something and renting that out to some tenant. This allows one to generate cash flows which is critical for a good investment.
2 This has to do with the fact that there's a relationship between CAGR and volatility. In particular, when volatility decreases, that increases CAGR all else being equal. See my discussion on the relationship between Arithmetic and Geometric Returns.

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