David from Seattle asks.

Your recent episodes on the Fed and the worrying size of their balance sheet are timely but also quite unnerving. Given the potential strong inflationary pressure in the coming years, two popular hard assets come to mind: gold and real estate. In terms of cash flow, gold bars generally don’t cash flow, whereas apartments can cashflow very well. Moreover, fixed rate mortgage carried by most real estate also works for the owner under high inflation. On the other hand, physical gold is free of counter party risk, whereas real estate might have some limited counter party risk (e.g. from the mortgage). Which one is “better” in hedging against inflation? How should investors think about their asset allocation between gold and real estate as we head into inflation or even stagflation? 

I like how you’ve addressed gold and real estate in depth separately in many other episodes. I know quite a few investors have this gold vs real estate debate, and hence the question.

David, that’s a great question. I’m left feeling like it’s a little like asking which is better for you Broccoli or Tofu. The truth is you need both vegetables and protein. It’s not really a choice between one or the other. Rather it’s a question of proportion. 

You are correct in stating that gold has no counter party risk. For those who don’t know or don’t remember what counter party risk is. If I loan you money, that loan shows up as a liability on your balance sheet and as an asset on my balance sheet. However, it remains as an asset as long as you repay. That asset is said to carry counterparty risk. The reason the financial system nearly collapsed in 2008 was because of counter party risk. Holding the physical metal has no counterparty risk. If you hold gold certificates, you are holding a claim on gold. That claim is subject to counterparty risk. 

In terms of creating long term wealth, real estate is an effective hedge against inflation. As you pointed out in your question. I firmly believe that governments are under-reporting inflation. Not only are there multiple reasons for them to do so, there is ample evidence that they are in fact under-reporting inflation. 

We don’t typically leverage our ownership of precious metals. Whereas real estate is much better suited to leverage. Here too, the leverage must be responsible. Too much leverage would expose you to financial risk. But generally speaking, with income producing assets, leverage can be your friend. Inflation increases rents. Inflation pumps up asset prices.