jlcollinsnh:
Inflation is, of course, the process of prices increasing. For the last several years the Federal Reserve has been trying hard to ignite a bit of it into the economy. Mostly to stave off the prospect of deflation and collapsing prices, but also because modest inflation, as you suggest, is good for businesses. It allows them to raise prices and wages while posting greater profits.
The problem comes when inflation rages out of control. In that scenario, business finds it far more difficult to keep up. Credit becomes tight and extremely expensive. Lenders demand huge interest rates to compensate for the increased risk of being paid back with currency rapidly dropping in value, perhaps to the point of worthlessness, as in Germany in the 1930s.
All of this combines to overwhelm a company’s business and in the process destroys the value inflation would have otherwise created.
In times like these, money flees into tangibles and real estate is perhaps the most favored.
Of course, REITs are made up of real estate businesses like office and apartment buildings. These are also not immune to serious hyper-inflation.
I confess that sometimes I wonder if I really need the REITS and holding just stocks and bonds appeals to my preference for simplicity. But each time I review it the value of the extra (if not perfect) hedge wins out. The higher dividends don’t hurt either.
As you might be able to tell, I wasn’t entirely comfortable with this explanation. Since I had the sense that Paul is an astute guy, I asked him for more on his perspective.
So this will be somewhat a whacky economist’s point of view (both my job and education).
I guess part of my reluctance to buy into REITs is from looking at the fundamentals. Land itself is not a productive asset. Therefore, unlike stocks which are based on companies, it cannot increase in productivity. Any capital gains on real estate is due to some other factor.
Now, this can be for legitimate reasons (I live in Houston and houses are getting more expensive due to an influx of people), but it can also be for silly reasons. Up until the late 90′s when we as a country decided everyone should own a home and incentivized it, housing prices essentially tracked inflation. There were no capital gains.
http://cdn.uncommonwisdomdaily.com/wp-content/uploads/moneyandmarkets.com/UWD/104/housing-prices.gif
That means if I am hoping for anything in excess of the high dividend I have to assume the REIT owns property where demand is increasing, or rely on the government to continue to incentivize or boost real estate sales somehow. I suspect (and this is my wild guess) that the latter is not sustainable indefinitely. I already rent on a 6 figure salary because housing is a poor deal and I live in one of the cheaper big US cities.
Now, the higher dividends are nice, but the economist in me is doing some NPV (net present value) discounting and wondering if that’s not just trading dollars now for higher dollars in the future. That’s not to say that’s a bad decision if my time value of money is lower than most people. I suspect that is a true statement for most people on this website.
To get back to my original question, as far as why REITs for an inflation hedge, the problem I still have is this:
At best, they will beat stocks when we are incentivizing home ownership. At worst, they are likely (on average) to match inflation from a capital gains point of view and provide a healthy dividend. Now, neither of those is bad, but neither captures the value of increasing productivity like the stock market does.
The reason I’m asking here is because I can’t find good data on the historical returns of real estate vs stocks. Most of it is focused from 2000 onward.
As far as the potential for hyperinflation, I’m not sure either asset will do great in those cases. I can’t imagine selling a house is much more fun than selling a burger in a time of hyperinflation.
Essentially I still kind of see REITs as similar to investing in gold. Any capital gains rely on changes in demand and supply rather than fundamental increase in productivity. Caveat here that real estate is at least far more useful than gold, which is why you see the higher stability in prices.
Anyway, thanks for your thoughts. I don’t disagree with any particular point, but like you I wonder if REITs are needed. Right now I own none, and I am leaning toward staying with just stocks and bonds.
jlcollinsnh:
Thanks, Paul, for the great and well thought out analysis. Very helpful as I re-evaluate my thinking on these things.
I’ve held them for the hedge against high to hyper inflation and to a much lesser extent for the income. While something like land might serve this role, it occurs to me once you start adding buildings RE has really become a business like any other and as such it is just as susceptible to the ravishes of hyperinflation as any other.
REITs, of course, hold mostly apartments and commercial buildings. I’m very close to changing my position on this. With that in mind, any further REIT thoughts? Also, what would your choice be for a hedge against hyperinflation? My guess is most would say gold. But I gather that, like me, you are not a fan of the metal….
Paul
You’re correct that it wouldn’t be gold for me.
Honestly, I take MMM’s wild optimism here. I assume it’s not going to happen. There’s a few reasons for this.
Primarily, hyperinflation is just hard to plan for and to truly be protected from it I think you’d have to allocate a huge amount of resources that will then otherwise underperform.
Secondly, if the US goes in to hyperinflation I think the saying “You can run, but you can’t hide” would become painfully clear to the whole world. The US economy is such a central feature to the world economy that I think it would be hard to avoid the consequences with any typical assets.
Thirdly, if we look at the German stock market performance during their hyperinflation, it’s really not that bad, even in USD terms.http://www.businessinsider.com/heres-what-happened-to-stocks-during-the-german-hyperinflation-2011-11
Not bad as far as hedging a black swan.
Lastly, I think it’s something you could somewhat see coming. Once you know hyperinflation has arrived, I’d do things like hold foreign currency and/or say, cattle. I’d still avoid gold because foreign currency is a better medium of exchange and a steak is way more useful to someone on a monthly basis than a gold brick. In basically every hyperinflation situation we see that people are remarkably flexible. Barter systems spring up, so goods that are useful short-term (food, gas, clothes, etc) are going to maintain similar relative values.
Due to all of that, I just don’t really think it’s a situation worth hedging against. Ultimately, going back to MMM’s optimism, the most important asset during hyperinflation is me. If I can maintain my usefulness, I can make my way through hyperinflation. I’m sure it’d set financial independence back for me (or mess up plans for those already in it) but long run, we’ll be okay.
As far as last thoughts on REITs, after our discussion I’d have to say this. I think they have their place in more active portfolio (say someone who does growth, value, small cap type break downs). I think there they can make sense so long as you are following market conditions and keeping up with potential legislation as far as home ownership. Otherwise, in a fire and forget type portfolio, I have to agree with your conclusion, they’re essentially a specific business, and I think they won’t offer any substantial difference compared to a stock/bond portfolio.
I think international exposure would give more diversification although even that seems to correlate more and more with US performance. I lean toward the keep it simple approach. I enjoy talking about this stuff, but I don’t enjoy tracking finance news to the level required for anything beyond a big dumb stock/bond index portfolio.
If you want real estate as a hedge to hyperinflation (along the lines of my cattle ownership) I think you’d have to physically own the land with all the joys that entails.
So, there you have it. While the REITs have been a solid performer for us, they really aren’t well suited for the serious inflation protection role for which they were bought. For these reasons,
later today I’ll be entering an order to
sell our REIT fund VGSLX and roll it into VTSAX.
Since these are mutual funds rather than ETFs, this trade will execute at the market’s close. When the dust settles our allocation will be 75% stocks/25% bonds. (It had been ~50% VTSAX, 25% Bonds and 25% REITs) Since REITs are a form of stocks, essentially our allocation remains the same.
But what about an inflation hedge?
Well, first remember that stocks serve that function well in all but the worst hyper-inflationary times. Then take a look at that last link Paul provided on how the German market performed during the 1930 when they went thru perhaps the most famous hyper-inflation in the developed world’s history. Pretty encouraging, especially considering that true hyper-inflation is a pretty rare thing and, as Paul suggests, something that we should be able to see coming. But I am pondering some alternatives, some along the lines Paul mentions.
Harry Browne wrote one of my all-time favorite books:
The problem with this, as I see it, is that financial disasters are actually rare events. Structuring a portfolio focused on disaster carries a very high cost in lost opportunities when times, as they most often are, are more normal and prosperous.
The value of cash is relentlessly eroded over time by even modest levels of inflation. Gold, Browne’s inflation hedge, has no earning potential. In fact some, like William Bernstein (from this Forbes article) suggest that gold isn’t all that good an inflation hedge anyway:
“Commodity producers, it turns out, have worked better. The cheapest solution is to hold an internationally diversified stock portfolio, so that rampant inflation in the U.S. can be offset by more stable returns from foreign stocks. A long-term, fixed rate mortgage tied to a house not purchased in a bubble will also offer an offset. Finally, there are inflation-protected bonds (TIPS) for those who want them.”
Well we already own the commodity producers in VTSAX and TIPS are paying well under 1% in interest, making them very expensive inflation insurance.
A long-term mortgage is an interesting idea as in effect you are shorting the US dollar. The major drawback being the inflation protection is heavily weighted toward the early years and disappears completely as it is paid off. As Brett Doyle says in his comment on my post Why your house is a terrible investment (See Addendum #3):
“Having a mortgage is a great way to short the US dollar because of the long maturity and low rates…make sure to constantly take all of the equity out…because our society has decided that homes are the “chosen” asset class and distorts the market by redirecting resources into mortgages it makes sense to buy a home. I would never even consider buy a home with my own money, but hey, if the US taxpayer and a bank is dumb enough to loan me several hundred grand at 3% for 30 years and give me a tax deduction sure why the hell not.”
But what really caught my eye was this suggestion: “an internationally diversified stock portfolio.” Very intriguing. Even more so when in the same article it is claimed this is also a sound deflationary hedge (along with gold – better than for inflation actually – cash and long-term Treasuries).
Mmmm. Adding an international stock index fund might serve as a hedge against both inflation and deflation? Very interesting concept indeed!
For reasons I describe here, I don’t see the need to hold an additional international position once you have VTSAX. Those reasons still hold true, but this new angle just might change my thinking. I’ll need to ponder and research it a bit more.
Of course, this is also similar to Paul’s suggestion of holding foreign currencies, and for the same reason. At least until we have a meltdown when you’ll want food, gas, clothes and cattle to barter.
Or as Rich added, somewhat tongue-in-cheek, to that May ’14 Ask jlcollinsnh conversation:
“In prison cigarettes are always worth something, Buy them now and hold for future resale. Now that’s an inflation hedge. Maybe sugar too.”
A final thought. As of last Friday, May 23rd, VGSLX (my REIT fund) is up ~15% year-to-date and has still not reached its high set back in February 2007. On the other hand VTSAX (my stock fund) is only up ~2.5% so far this year and is right at its all time high; as is the stock market (S&P 500) itself, having just closed over 1900 for a record. So why sell the better performer to move into the laggard, especially with that laggard at all time highs?
Simple. I only buy or sell for strategic purposes such as this change in our approach. Never as an attempt to time the market. That’s a fool’s game. I have no way to know if the recent trend for these two funds will continue. No one does. For more on why see: Investing in a raging bull written almost exactly one year ago.
Importantly, since we hold VGSLX in our IRAs, we can sell with no capital gain tax concerns.
This post is only sharing a change in what we are doing and why. It is not meant to suggest that if you own REITs you should also sell them. That is a decision that depends on why you own them and the role they play in your portfolio. They can be fine additions to a portfolio and were to ours for many years.
*Note concerning the painting:
When I asked my pal Alex to suggest one of his paintings to illustrate “stepping away” he sent me Samsara, along with this note:
“…this is as stepping away as you can get. Buddhists believe that there is a ladder of sorts that we ascend (or descend) during the cycle of life, death, and rebirth. We are rewarded for good works in one life by ascension to another life with better circumstances. The eventual destination is Nirvana, or Oneness with all things. This painting illustrates the passage of a soul from one vessel to the next, and for a moment is noticing that there is something else and is hesitating.”
Note 2:
This move from REITs is a fairly big step and it has required going thru editing and/or adding notes and addendum to the posts where references to REITs and VGSLX appear. Seems there are many more than I realized. I think I got most, if not all. But if you see one I’ve missed, please call it out in the comments below and I’ll get it taken care of. Thanks!
Samsara
An original painting by Alex Ferrar*
Last week I received a comment from a reader named Paul. In it he asked this very provocative question: “Curious why you view REITs as an inflation hedge any more than stocks are an inflation hedge.”
As it happens, that’s a question I’d been pondering a lot of late. Regular readers will know, as described in the posts What we own and why we own it and Stocks Part VI: Portfolio ideas to build and keep your wealth, I personally keep 25% of our portfolio in REITs. Specifically VGSLX (Vanguard REIT Index Fund).
Real Estate Investment Trusts (REITs) are mutual funds that invest in real estate. My thinking was they would serve as an inflation hedge. The idea being in times of inflation people flee cash and buy tangible assets, like real estate. The fact that VGSLX pays about a 3.5% dividend was a bonus.
Now while I like to receive dividends as much as the next guy, for reasons I lay out in the post Dividend Growth Investing I am not a fan of pursuing them as a portfolio strategy. Suffice to say the dividends were a very distant secondary consideration. Still, they provided a stark advantage over, say, gold.
The point Paul was correctly making is that stocks also serve well as an inflation hedge. It is a point I’ve also made, for instance in the first of those posts linked to above:
“Stocks are, over time, a fine inflation hedge. People forget that stocks are not just pieces of paper. Stocks are pieces of ownership in operating businesses. Sales, inventory, plants, equipment, brands et al. All of which rise in value with inflation.”
My concern was that during periods of intense hyper-inflation that might not hold true and the damage to the economy would overwhelm the ability of businesses to deal with it. Real estate as a tangible asset held by my REITs, would hopefully do better.
For inflation of modest to modestly severe levels this might well be true. Although, upon further reflection, not so much as I might have hoped. Worse, should the problem ever reach hyper-inflationary levels, REITs would very likely fair no better than the broad portfolio of stocks held in an index fund like VTSAX.
The problem is that REITs are made up primarily of companies that hold office buildings, apartment buildings and the like. Once you put a building on a piece of land it effectively becomes a business with the same potential and shortcomings of other businesses. That’s fine in times of normal to high inflation. In times of hyper-inflation we’re asking too much of it.
Here, with some editing for space, is the rest of my conversation with Paul starting with my initial reply. If you are interested in the unedited version you can read it in its entirety on Ask jlcollinsnh starting on May 21, 2014.