Real Estate As A Hedge For Inflation

Includes: DHI, IVR, JOE, PMT
by: Lamarcus R. Coleman

Over the past few years, real estate has been one of the most depressed sectors. The financial crisis of 2008 resulted in record foreclosures, driving the value of real estate down. The residential sector was at the core of this debacle. Some time thereafter I began recommending multifamily homes, and commercial property or REITs containing such. In the wake of a residential housing meltdown, high foreclosures, plummeting prices, I felt that past home owners were going to find refuge in apartments, and other multifamily homes. To date, we have experienced a tremendous improvement in the housing sector relative to three years ago. I now feel its time to move back into the residential sector.

Sales of new and existing homes have been up. Housing starts have improved as well. Interest rates are at record lows, which is an incentive to purchase homes. The Federal Reserve expressed a desire to maintain a low interest rate environment through 2014. However, according to the National Association of Realtors, the Reserve may have to raise interest rates prematurely to cope with rising inflation in the coming years.

The CPI, which gauges the rate of inflation, or decline in purchasing power, was up 2.2% year over year in October, vs. 2.0% in September. The Core CPI, or the measurement of the increase in inflation less energy and food prices, was up 2.0% in October, matching that of the prior month. The National Association of Realtors expressed in a recent report that core inflation is above its desired level. This is attributed to rising rental prices (hence, my recommendation in prior years of multifamily REITs), which are expected to continue to increase. The National Association of Realtors projected that inflation could hit 4-5% as a result of the Fed's tolerance of low interest rates.

Real Estate, for the course of the next few years, is a must for your portfolio. Housing starts will continue to increase. Home prices will rise. Housing starts have risen by 25% to date. Inventories are falling, thus creating a need for more production. Housing starts are projected to increase by 45% in 2013. New home sales are projected to increase an additional 50% in 2013. The chart below from the National Association of Realtors shows that the inventory of new homes is depressed.

Housing Inventory
(Click to enlarge)

Median home prices are projected to rise 6% in 2012, and by 5% in 2013. Low levels of inventory will weigh somewhat on prices. Payrolls are forecasted to be higher in the coming years, thus increasing the vitality of the housing market. With inflation projected to increase in the coming years, investors must take action now. The real-estate sector is a key addition to your portfolio. Inflationary pressures are rising as a result of government spending, quantitative easing, increasing rental prices, etc. To offset this increase, investors should seek refuge in the residential sector. With increased demand and low inventory, home prices will continue to rise.

Two key ways of playing the rise in the housing market are by investing in real-estate investment trusts, REITs, or real-estate focused mutual funds. REITs can be classified as equity, mortgage, or a hybrid of the two. REITs provide investors with a great way to benefit from the increase in property values, rents, and new home sales. Equity REITs generate revenue from rental income of the properties owned. Equity REITs are especially advantages in the wake of the data provided by the National Association of Realtors. With the Core CPI being largely supported by rental expense, and rents expected to continue to increase, equity REITs will appreciate over the coming years. Mortgage REITs lend capital for mortgages or buy mortgage backed securities. The projections of a substantial increase of new home building in the coming years provide a catalyst for mortgage REITs. In an environment in which inflation will rise, interest rates will have to be elevated from current levels. Mortgage REITs will benefit in the current environment as interest rates remain low. Once interest rates rise, mortgage REITs will decline in value. One strategy is to buy Mortgage REITs in the short term and Equity REITs over the long term. REITs raised $60 billion the first ten months of the year vs. 51.28 billion for the entire year of 2011. This marks a record for capital raising.

The St. Joe Company (NYSE:JOE) has outperformed the S&P 500 over the past year. The company is primarily engaged in residential and commercial real-estate in Florida. Florida is one of the top two turn around states for real-estate. The company is less leveraged than that of the industry.

Invesco Mortgage Capital (NYSE:IVR) is a REIT that is focused on residential and commercial mortgage back securities. It has outperformed the broader market since the end of the 1st quarter. At its current price, it has a yield of 13.11%, and closed up 5.76% Friday, off 8.36% from its 52-week high. The company has no leverage relative to the industry average, and is more profitable than the industry average.

PennyMac Mortgage Investment Trust (NYSE:PMT) is a REIT that invests in mortgage loans and mortgage related assets. The company is trading above its 100 day moving average and has outperformed the S&P 500. It closed higher Friday, up 3.77% on low volume.

While the mentioning of the fiscal cliff has become monotonous, it is the biggest consideration of investing right now. Should we fall off the cliff, and may I reiterate that I believe Congress will kick the can down the road a little further, it would change a lot in the way of taxes. Taxes on dividends would go up dramatically, while capital gains taxes would increase from 15% to 20%. If you believe that the fiscal cliff is the most likely scenario, you may want to purchase real-estate mutual funds, as an alternative to REITs. The reason being is that REITs must distribute 90% of their income, giving them high "dividend" yields which would be subject to an increased tax rate should the fiscal cliff materialize. If you hold your real-estate mutual fund investment longer than one year, it is taxed as capital gains. This is an extremely advantageous way to hedge against the potential cliff, and the resulting increase of the taxation of dividend income.

Another alternative would be to go long the homebuilders. The homebuilders are up 33% over the last six months. In this sector I like D.R. Horton (NYSE:DHI). The company is 17% off of its 52-week high. The company appears to be selling at a discount, with a PE and PEG below the industry average. The company also has one of the more advantageous profit margins in the industry. The stock closed up 2.33% Friday and is trading above its 200 day moving average. I recommend scaling into a position, building on it as the stock crosses its 100 day moving average.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.