Why the art of the deal is still in real estate, not in galleries

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Castlestone Management, a New York–based money manager, recently launched a new fund with an unusual specialty: art. "The fund is designed as an anti-inflation shelter at a time when recession-busting stimulus packages are flooding the global economy with cash," Bloomberg reported last week. "To Castlestone, which has some $660 million under management, scarce art -- by dead artists, or by big names in late career -- is as good as gold."

The plan is simple: Raise money from investors to buy art, then wait eight years and sell it at auction, making millions after inflation has driven the value of hard assets through the roof. The fund has already acquired $16 million worth of artwork and plans to buy $9 million more by the end of September. If all goes according to plan, that $25 million in artwork will be worth far more than what it cost Castlestone.


Sound like a good idea? I don't think so. The reason why art is a lousy inflation hedge can be summed up in one word: leverage. If you expect serious inflation, the best thing to do is borrow as much as you can at today's ultra-low interest rates using a fixed-rate loan, and then plow it into hard assets. Once you get past the murky world of futures (which can be used to speculate on classic inflation hedges like gold and oil), the best option for that strategy is real estate.

With a 20 percent down payment, you can own a piece of property with a an interest rate below 5.5 percent -- still historically low, even after the last month's bond price beatdown -- and sit back. Best of all, many markets offer a wide selection of real estate at prices far lower than it would cost to rent. So your tenants can pay your mortgage, taxes, and insurance, and increase your cashflow.

Why is real estate so much better an investment than art? Let's look at some numbers. Say we hit some really serious inflation, and art appreciates at an annual rate of 18 percent, while real estate goes up just 6 percent per year: both high numbers, but not impossible in an era of high inflation. Here's how it would work:

  • John spends $100,000 in cash on an art collection worth $100,000. After eight years of appreciation at 18 percent per year, his collection is worth $375,885.92, and he's made $275,885.92.
  • Mary spends $100,000 in cash on a down payment for real estate worth $500,000. After eight years of appreciation at 6 percent per year, her property is worth $796,924.04. When she sells and repays her $400,000 mortgage, she's made $296,924.04.
Aha, but what about maintenance and insurance? Surely Mary is paying much more than John to care for her property than he is. But Mary can cover those costs with rental income. John can't. So, all things being equal, Mary comes out ahead, even though the art appreciates at three times the rate of the real estate. That's the benefit of having low-interest fixed-rate debt financing hard assets in a time of high inflation. With real estate, inflation would tend to increase cash flow tremendously, because your mortgage payments stay the same while rental prices soar.

It's possible that even with the leverage advantage real estate has, art will still outperform it. But the rate of return would have to be so much higher that it's not a bet I think anyone in their right mind would make.
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