How to Hedge Real Estate

How to Hedge Real Estate

© Martin A. Armstrong

Hedging real estate always offers a few new problems. Some will argue that buying gold will provide an adequate medium to hedge against a collapse in real estate. Such suggestions usually tend to draw on 1929 as an example. As usual, suggestions of this sort know a little about history but not enough. They fail to point out that gold was money so a rise in gold was actually a rise in cash – a significant difference from gold’s position today. Gold is a commodity that has declined in harmony with real estate during recessions. Obviously, such a hedging proposal could end in disastrous circumstances.

Hedging real estate is certainly a difficult problem. They did have a very clever idea back in 1929. Just a few months prior to the famous peak in 1929, the real estate futures exchange opened for business in New York. The concept was to take a known major building in downtown Manhattan. That building would represent a given standard value against which everyone could then buy and sell contracts relative to that standard. It was actually a nifty idea. Think of it. Real estate does represent far more wealth than any other instrument. In total, real estate is worth more than the entire world’s GNP more than 10 times over. Unfortunately, when the crash began, there were no bids for real estate so the exchange folded shortly thereafter.

Lacking a futures contract, real estate still remains one asset, which is difficult to hedge in a proper fashion. It becomes the most illiquid asset in a recession and its value can become quite volatile.

Perhaps the simplest means of hedging real estate, short of selling it, is simply to mortgage it to the hilt. Of course there is another important aspect. The mortgage must be at a fixed rate and the proceeds must be TOTALLY reinvested in HIGHLY liquid assets.

For example, if you have a lot of equity in a home, you might be a lot better off taking out a full mortgage for as much as you can possibly get your hands on. Take the money and then buy T-Bills – NOT bank CDs. In a crisis, CDs could be discounted if the marketplace decides it does not like your particular bank.

Investing the proceeds in government Treasury Bills offers security and liquidity. With short-term rates tending to rise more rapidly just prior to a recession, the spread differential between the mortgage and T-Bill rate will narrow. Keep the T-Bills rolling in 30 day units. This will maximize the benefit obtained during rising interest rate periods. Make sure that the T-Bills are actually in your name. Don’t leave them in a brokerage account or in a bank other than the one which grants the mortgage. That way if the worst-case scenario takes place you would get caught in someone else’s nightmare.

This strategy will offer one very important protection plan. During a recession, assets decline in value and cash rises in value. Therefore, even if the real estate falls by 50%, you already have 100% in cash. That cash can then be used to buy other real estate or simply provide the much needed liquidity that becomes so scarce in those situations.

The downside to this strategy is simple. It will usually cost you a few points to get the mortgage and there will be a slight negative cash flow when your income from the loan proceeds remains below the outflow required to service the mortgage.

As long as you do NOT spend the cash on unnecessary things or invest it in mutual funds, stocks, bonds, commodities or anything else, which might go down during a recession, you will find that you will have ample cash when it is the most advantages.

This is a simple technique that will lock in the present value of your real estate today. In fact it may be the only means of protection that really works when the chips are down. Of course there is nothing that can guarantee success. When crisis hits, all bets are usually off. However, this strategy would have worked for all major recessions including the 1929-1932 period as well. The nice thing is that if your particular piece of real estate still goes up, you still participate in all the gains.