John M. Lee: Real Estate as Inflation Hedge

Remember a few years ago when economists were worried about deflation, the fear that the prices of goods would actually go down? Well, no more. Now they are concerned about inflation and how it would affect our economy.

But, before that, kudos to our outgoing Federal Reserve Bank Chairman Alan Greenspan - who has guided our economy with his monetary policy since 1987 - for a job well done. Everyone knows that our gas prices have shot through the roof. And despite some decreases in these past weeks, they are still 20 to 25 percent higher than at the beginning of the year.

Our PG&E bills are higher, insurance rates have increased and housing prices, including rentals, are going up as well. The inflation rate is most often associated with the Consumer Price Index (CPI). The Bureau of Labor and Statistics puts together average prices for various items, such as food, energy, housing, apparel, transportation, education and medical care, and calculates how much it changes over time.

In the past few years, we have been increasing at 2 to 3 percent a year. This year, it will probably be 4 to 5 percent. With the increase in oil prices, which propagates throughout most of our expenditures, and natural disasters, such as Hurricane Katrina, that will indirectly affect our insurance rates, inflation will most likely go up in the near future.

But what does this mean for real estate? For one, interest rates will go up. Short-term interest rates have gone up due to the Federal Reserve Bank increasing the rates the last 16 months. Long-term interest rates have started to go up somewhat lately and will probably go up some more next year. For those who already own real estate and are locked into a fixed rate mortgage, this might not be a bad scenario.

In San Francisco, most new owners are spending about 40 percent of their income on housing, and if their income goes up because of inflation (I can still remember getting 10 percent cost of living adjustments back in the '80s) and their housing expenses stay relatively constant, they will be paying off the loan with post-inflation dollars, which are worth less than pre-inflation dollars.

For example, it is much easier to make a $2,500 mortgage payment today than it was 15 years ago because $2,500 is worth less today. Also with inflation, income rises and prices rise, including real estate.

Academic research has shown that real estate is a hedge against expected and unexpected inflation, meaning that it's the perfect hedge if one believes that inflation is on the horizon. The next few years should prove to be very interesting economically and the new Federal Reserve chairperson will be inheriting an economy growing at a healthy pace, despite blows from Gulf Coast hurricanes.

But he will also quickly face a number of difficult issues, including growing inflation and high energy prices, the forecast slowdown of a red-hot housing market and historically large trade and budget deficits.

If confirmed, Bush nominee Ben Bernanke likely will also have to decide, with other fed officials, how and when to wind down the central bank's 16-month campaign of raising interest rates.

John M. Lee graduated with an MBA from UCLA and currently is a real estate broker at Pacific Union, specializing in the Richmond and Sunset districts. If you have any questions, call him at (415) 447-6231 or e-mail johnlee@isellsf.com.