AMA - Hedging Strategies

Tom asks,

First of all, thank you for your dedication to provide as much value as you do on such a remarkably consistent basis. I own a portfolio of multi family properties with about 2/3 debt and 1/3 equity. Almost all of my net worth is in my real estate holdings. The way I see it, I am long economic growth and inflation. I’d like to buy a hedge so that if we get hit with a contraction or deflation or spike in cap rates that decrease values, the hedge pays off. How would you - or do you - hedge? Which financial products would you consider?

Tom,

This is a great question. I’m hearing a couple of assumptions and questions wrapped up in your question. The first is that we could see a market down-cycle at some point in the future.

The challenge with pure hedge investments is that they tend to be short term. I’m thinking of options to sell shares in the stock market. That’s a traditional hedge. But you need to time the market pull-back correctly for that to work. Unless you have a strong analysis team and have developed an expertise in hedging, it’s very difficult as a short term strategy. Longer term hedges are more moderated in approach.

I think the basic premise of using inflation to give you leverage is sound. We have gone through nearly a century with no sustained reversal of inflation. If you’ve been listening to this show for a while you know that inflation can be your enemy or your friend, depending on which side of the trade you are participating in. Inflation devalues the purchasing power for those on fixed income, it devalues cash savings and it devalues debt. Inflation results in higher asset prices for real assets which provides an effective hedge against inflation.

Your strategy is the right one in my opinion. In this instance, leverage is your friend. It means that even in an environment of slower economic growth, or perhaps economic stagnation, if inflation continues, the benefit goes to the equity side of the equation. You don’t want to be so highly leveraged that you build a house of cards.

The most important thing is to protect your assets. The first step in doing that is to convert your debt from recourse debt to non-recourse debt with the longest possible term. This may sound like a small point, but it’s not.

Recourse debt has a personal guarantee associated with it. While you’re probably investing through a corporate entity, you probably have personally guaranteed the debt. But if the debt is non-recourse debt then you get to keep the asset on your personal balance sheet, and you don’t need to report the debt on your personal balance sheet.

You also want to maximize your cash position by maximizing your leverage. Once you’ve done that, you can purchase additional inflation hedges. I’m thinking specifically of gold. When I say gold, I’m talking about the physical metal.

Gold is a very liquid asset and it’s also a pretty good store of value. It’s an effective hedge. The critics of gold would say that gold doesn’t cash flow and therefore they don’t consider it to be a very good investment. They would say that gold goes up and down and that investors pile into gold during times of economic worry. Investors largely ignore gold in the good times.

You would like to use cash but your cash is tied up in gold and in properties. So you go to your cash rich uncle, or cash rich lawyer and negotiate a low interest loan where the lender holds the physical gold as collateral. The lender is completely secure in their loan. They’re holding highly liquid collateral. There is no need to qualify the borrower since this is an asset based loan.

The market has created a lot of value for equity investors lately. Some are using it as an opportunity to take some chips off the table and hold them in reserve for future opportunities when they arise. I personally think that gold is a good hedging strategy when kept as a liquid borrowing tool.