Commodities and Real Estate: Pros and Cons

No man acquires property without acquiring a little arithmetic also.

~ Ralph Waldo Emerson

Update: This article appeared in the Carnival of Financial Planning #153 at The Skilled Investor.

We continue our look at the prospects for various asset classes in the current market environment today with a survey of the commodities and real estate landscape. Both of these are usually considered hard assets. As Dennis Gartman always says, “if you drop them on your foot, they hurt”.

Generally speaking, hard assets like commodities and real estate tend to appreciate during inflationary times and depreciate during deflationary climates. So your view on whether to allocate money to these two may hinge on your position in the inflation vs. deflation debate. I tend to be in the camp that says we are currently in a deflationary environment, and likely will be for some time. But there is definitely the potential for inflation to rear its head down the road depending on the actions taken by monetary authorities.

Commodities: Will It Be the Elevator or the Stairs?

There’s an old saying on the trading floors that commodities take the stairs up, but the elevator down. Uptrends are usually gradual and orderly, whereas corrections can be fast and steep. Over the past decade or so, however, it seems like commodities markets are a lot more volatile in both directions. I’m not sure if it’s the number and complexity of ways to gain exposure to commodities or not, but the rise in volatility does seem to coincide with the proliferation of ETFs and derivatives.

Your choice of investment vehicle for your commodity exposure may determine your success as well. You can buy stocks in companies that mine or harvest various commodities like oil, gold, copper, or grains, or you can trade futures on the individual commodities. You can buy ETFs that can track a basket of commodity-producing companies, or a single commodity like gold itself. Just be aware that funds that track commodities don’t always track them as closely as you might like.

Here are some reasons that you may (or may not) want to put money into commodities right now:

Pros

  • Growth in emerging markets like China and India may fuel demand for everything from oil to potash.
  • If central banks monetize debt in order to avert a sovereign debt crisis, inflation could spike, taking commodities with it.
  • If the U.S. dollar (in which all commodities are currently denominated) falls, commodities usually rise.
  • If investors lose confidence in fiat currencies, they may flock to commodities, especially gold.

Cons

  • Commodities can be very volatile, and it’s easy to get shaken out of your positions.
  • If deflation takes hold for an extended period of time and the economy fails to recover sufficiently, commodity prices will fall.
  • If the U.S. dollar rallies because traders lose confidence in other currencies like the Euro, the Pound, or the Yen, commodities will likely suffer.
  • If there’s even a hint of growth slowing in China or other emerging markets, traders tend to sell commodities first and ask questions later.

It would be easy to spill a lot more pixels on each commodity individually, as each one has unique characteristics. These are meant to be generic guidelines for investing in commodities. Given my view that deflation is the main worry right now, I favour a cautious approach to commodities. Still, the longer term growth story for commodities is undeniable. The supply of most commodities is, after all, finite.

If you don’t mind volatility and are a pretty agile trader, you might consider a small core position in your favourite commodity companies or ETF (bought on a pullback, of course). You can always allocate some cash to trade the swings as well, but there’s no shame in sitting out for a while if you don’t have a trader’s disposition, or can’t afford the increased risk.

Real Estate: Location, Location, Location

It’s hard to talk about real estate as a single asset class, as prices can behave very differently depending on the specific market you’re discussing. As we all know, the real estate markets in Canada and Australia did not take the hit that the U.S. market sustained over the past few years. Whether those two commodity-rich countries will be able to escape unscathed or are merely trailing their American counterparts remains to be seen. (Update: Interesting article asking Just How Risky Are China’s Housing Markets?)

We can also make a distinction between the residential housing market and the commercial real estate market. I’ve always been of the opinion that my home is just that: home. It’s not an investment to be gamed. It’s literally the roof over our heads, and should be treated differently than a commercial property or even a vacation cottage.

Of course, there are numerous ways to gain exposure to the real estate market without moving every two years. You can buy rental properties, invest in commercial real estate, buy the stocks of home builders and related industries, or simply buy a REIT (Real Estate Investment Trust) or two and collect the distributions.

Here are a few reasons why you may (or may not) want to invest in real estate right now:

Pros

  • Home prices in the U.S. have already fallen so much that they may be ready to bottom.
  • Canadian home prices may correct a little, but won’t fall off a cliff.
  • Increased foreclosures may mean that you could find your dream home for a bargain.
  • If inflation takes hold, real estate prices usually rise.
  • Commercial real estate isn’t in as dire straits as some think. Securitization and financing are available.

Cons

  • U.S. home prices have further to fall and it may take another 5-10 years before they experience a meaningful bounce.
  • Canadian home prices are in a bubble and are due for a serious correction.
  • Many commercial real estate loans are coming due over the next couple of years and they may not be able to roll that debt into new loans.
  • The glut of homes on the U.S. market will only get worse as banks foreclose on more homes, driving prices down further.
  • The expiration of the stimulative home buyers’ programs that have supported the market will mean lower U.S. home prices.
  • If deflation really takes hold, prices in the U.S. could remain depressed for some time, and those in stronger markets could experience deeper corrections than many currently expect.

If you think it sounds like these two camps are looking at two different markets, you’re not alone. I’ve read articles and seen various interviews with pundits who have argued each of these conflicting points persuasively. Maybe the recent market gyrations actually make sense when you look at the cross-currents that seem to be present. So what’s an investor with available cash to do?

I tend to be very cautious, and there are enough concerns out there right now that I prefer to sit on the sidelines. As a result, I might miss the train as it leaves the station. But one thing I’ve learned about markets over the years is that there will always be another train and I’d rather catch the second than get run over by the first.

What are your thoughts on the current state of the commodities and real estate markets? Are you putting money to work, staying the course, or sitting on the sidelines?

(Disclosure: I don’t own any of the securities or investment vehicles mentioned in this article at the time of writing.)

Written by Kim Petch

10 Responses to Commodities and Real Estate: Pros and Cons

  1. Hi 2 Cents,

    Right now my portfolio is 100% into commodities, majority in energy. I like to invest in Canadian junior oil/gas producers. We are still reliant on fossil fuels and in the coming years the increasing demand from emerging markets will gradually push the prices higher. Anyway you look at it, Oil will see 100$/bl again in the near future unless the global economy crashes in flames.

    Just my 2 Cents ;)

    • 2 Cents says:

      I guess you’re not a believer in the merits of diversification. ;)
      I can’t disagree that oil has the potential to hit $100/barrel (or higher) at some point but I couldn’t put that much money into energy with the economy the way it is right now and sleep at night. I wish you success with your portfolio. Maybe one of those juniors will hit it big!

  2. The Canadian housing market is quite high; I agree! I don’t know if you can truly say it is in bubble territory, though. In many areas, rents are not far off from real estate prices. The rent vs buy calculation is one indicator of an unbalanced situation.

    Oil plays such a big part of our economy, and it will take some advanced solar power or fusion before we truly wean ourselves off of that. Even then, we will still need a supply of hydrocarbons for materials such as plastics and fertilizers.

    • 2 Cents says:

      The bubble question probably won’t be solved until it either pops or doesn’t. I’ve heard convincing arguments for both sides.

      I agree with you on oil. If the price falls, it’s unlikely to be because it’s been supplanted by green alternatives for quite some time. It would more than likely fall due to economic concerns or a general flight from risk assets.

      Thanks for weighing in! :)

  3. Very good post, really good stuff.

    I took note of your comment on Canadian real estate being quite high. I’m from the States – Chicago, specifically – and have seen values here drop quite a bit, all things considered.In the suburban area in which I live, values have dropped at least 20% over the last few years.

    Anyway, your comment resonated because of what I have seen here, and what I observed on a visit to family near Toronto a few months back. They were showing me outlying areas that appeared to be booming, and told me about how home values were steadily increasing. It looked like the area around where I live from 6 or 7 years ago, and that type of valuation increase did not continue; rather, it quickly went the other direction.

    Granted, the two economies and time periods are a bit different, but it’s still interesting to observe these similarities.

    • 2 Cents says:

      Yes. The big debate surrounding the Canadian housing industry is whether we’ve dodged the bullet that hit the U.S. or whether it’s just about to hit here. I’m not sure which is the truth. Housing in my city a few hundred kilometers south of Toronto did not experience the boom we’ve seen in Toronto, Vancouver, and other large cities. Hopefully, we will not experience as much of a correction either if one is in the cards for Canadians.

      Thanks for your comments. It’s always great to hear first-hand economic reports! :)

  4. This is interesting. There are certainly some markets in the U.S. that never experienced the home value depreciation. Hopefully, Canada & Australia will escaped unscathed. One more thing that you have in your favor was that while the banking industries in the US and Europe were much more reckless, Canada was MUCH more conservative and still has a vibrant real estate market (from my understanding).

    • 2 Cents says:

      Our real estate market and banking system are quite a bit healthier than those in many other parts of the world, but we’re not immune to the global macroeconomic climate, so I think it’s important for us to remain vigilant and not get too complacent.

      Thanks for your comment! :)

  5. I was really impressed with your blog and I must say, you are a pretty good writer my friend.

  6. H.H.H says:

    Asset Allocation, betting on one horse to win is Gambling NOT Investing.
    40/30/10/10/5/5 % works well,individual decided What and Where.
    Moi, Fixed Income, and Solid Dividend Stocks are my 40/30.

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