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Inflation Hedges Yielding 3%-18%

June 16, 2011 – by Richard Band

When looking for world-class inflation hedges, it pays to not over think the challenge. With home prices deep in the doldrums, I sniffed out bargains inflation hedges in single-family real estate.

In some hard-hit localities, it’s possible to rent out houses for a current cash yield of 10% to 12%, net of taxes and upkeep. Plus, you’re likely to enjoy substantial appreciation down the road, when buyers finally crawl out of their foxholes.

According to a recent study by Deutsche Bank, the 10 U.S. metro areas where rents will cover your after-tax costs by the widest margin are:

  • Atlanta (1.51x)
  • Orlando, Fla. (1.37x)
  • Rochester, N.Y. (1.36x)
  • Cleveland (1.33x)
  • Tampa/St. Petersburg, Fla. (1.32x)
  • Las Vegas (1.25x)
  • Jacksonville, Fla. (1.23x)
  • St. Louis (1.23x)
  • Buffalo, N.Y. (1.22x)
  • Memphis, Tenn. (1.22x)

If you live in one of these areas, today’s home prices may present the best investment opportunity you’ll come across for the next decade or more.

Of course, not everyone is cut out to be a landlord. For those who prefer hammocks over hammers, I recommend buying shares of a well-managed mortgage fund.

Aggressive investors might consider Invesco Mortgage Capital (NYSE: IVR), a real estate trust that counts billionaire Wilbur Ross among its advisers.

At the prevailing dividend rate of $1 per quarter, IVR is yielding — hold your hat! — 17.5%. That’s high enough to top inflation by almost anybody’s reckoning.

Bear in mind, though, that IVR is a leveraged vehicle, which adds risk. The trust borrows about $4 to $5 for every dollar of shareholder equity, using the proceeds of the loans to buy additional mortgages. You’ll want to exit your position in IVR at the first sign that the Fed may be inclined to raise interest rates.

For a more conservative (unleveraged) route into mortgages, go with the DoubleLine Total Return Bond Fund (MF: DLTNX). DoubleLine’s yield is gradually coming down, but the fund is still paying 8.5%, based on the first three monthly distributions in 2011.

My final inflation hedge may surprise you. Many people don’t realize it, but certain blue-chip stocks have boosted their dividends, over the long haul, at a rate far surpassing the cost of living.

Take, for example, Johnson & Johnson (NYSE: JNJ). No other company in the health-care space can match the breadth of JNJ’s businesses, encompassing pharmaceuticals, medical devices and consumer goods (Band-Aids, Tylenol, etc.).

As a result, JNJ has been able to increase its dividend 48 years in a row (likely 49 when you read these words). And those “pay hikes” have been nothing to sneeze at: In the past decade, JNJ has more than tripled its dividend, for a compound growth rate of 12.9% a year.

I don’t know of anyone, even the most wild-eyed gold bug, who maintains that the actual U.S. inflation rate in the past 10 years has exceeded 12.9% annually.

Better yet, if you buy JNJ today, you’re getting in at an exceptionally generous yield — 3.4%, two-thirds higher than the average yield the stock has paid over the past 10 years. My guess is that, by the time another 10 years have passed, you’ll be looking at a 7% to 8% yield on today’s cost. How’s that for real inflation protection?