My Second Big Hedge - Mixing my two loves: Stock Market and Real Estate
Wednesday, March 7, 2012 at 6:59PM I am always trying to protect my downside because I do believe in being very concentrated in certain investments but always want to have protections because of my high concentration. From previous posts, you have seen that I have invested in the VXX due to my concern of volatile stock markets causing problems with my margin accounts that I use to purchase real estate.
One thing I have done recently is to protect myself for when natural gas prices revert back to normal levels. In Cleveland and Shaker Heights, all of my properties are properties in which the landlord (me) is responsible for paying the heat bill. This is obviously in the form of buying natural gas from certain suppliers, such as Dominion East Ohio.
Anyway, back in 2008, I am sure you all remember oil prices sky-rocketed to $140 per gallon. This was not the only resource that sky-rocketed that year. Natural gas also hit very high levels. To put it into perspective, today I am buying natural gas based on a wellhead rate of $2.30 per MCF. Back in July 2008, each MCF was selling for over $11 per MCF. It was a scary time for landlords who pay the heat.
So when I am buying 4,000 MCFs per year, that’s a BIG difference in terms of profitablity of a property. We can’t pass the costs onto our tenants overnight. Raising rents and charging utility reimbursements take time due to new tenants coming in and being locked into previous leases, so I had to figure out another way.
UNG: This is an ETF that tries to replicate the performance of natural gas. It buys futures on natural gas that are traded. If you look at the chart on Yahoo Finance, it shows that back in 2008, UNG was trading at around $506 per share. It is currently at $18 per share. I have been buying on the way down since $50. So have I taken a beating so far? Yes. I bought at $50, $30, and $19 per share. So far, I am down 39% overall, which is a large hit, but you have to remember, I am not in this for the short term or for trading gains, necessarily. Yes, I will sell it if it spikes up considerably so I can lock in gains to help offset, but let me explain my main reason for buying.
Let’s say I have 30 units in Shaker that are worth around $40K per unit. That’s $1.2MM in value. Now let’s assume, under normalized natural gas markets, I am paying around $10 to $11 per MCF with all my distribution charges and such all included from Dominion. So I am probably paying around $6.5 to $7 per MCF as a base charge to me so MCF at the wellhead, that I described above, is around $5-$5.50 per MCF. So right now, I am spending about $40,000 per year in gas charge with everything included.
If my cost per MCF doubles, I don’t get an exact 1 for 1 increase in gas costs, thankfully, but it’s still around $20K in increased gas costs, which is BIG for a $1.2MM property. So what do I do? Well, not only do I lose $20K in cash flow, I also lose that in value because with increased expenses comes decreased profit. If I profit $20K less per year consistently my property is worth $240K or so less. My $1.2MM property becomes $960K pretty quick. Now, over time, I will be able to recoup those $20K in costs, but for the short term, I will hurt pretty bad.
Enter UNG: If gas goes back up to the 2008 levels, I will probably be spending $25K per year more in gas, which is about $300K in lost value. So I look at $300K in lost value and have to figure out what I need to make in profit under UNG to make it even.
So…$300,000 / ($506 - $30) where $506 is where UNG stood in 2008 and $30 is my current average cost basis in UNG. This comes out to a total of 630 shares. I take the 630 shares and mulitply it by the $30 per share I have and this requires an investment of $18,900 as a hedge against my future potential loss at my properties.
Now, am I skipping a lot of steps and assuming quite a few things? Yes. UNG went to $506 largely because of a big fear and rampant increase in gas prices, so that would have to happen again, you may think, in order for UNG to go to $506, and you are correct. However, I am fine with that. Why? I can easily absorb a slow and steady rise in natural gas prices. I can pass that onto tenants if needed. I do not want to absorb a quick run-up in natural gas prices.
The other plus of this is that UNG just provides more diversification for my portfolio in general. I have about 24% of my money in Cash currently, 54% in equities, and 22% in fixed income, so taking out some of the money from cash to put into this investment can diversify me as well as provide the hedge.
Finally, I think natural gas is a good long term bet. As the rest of the world develops more, there will be more demand for natural gas, as well as other natural resources, so with increased demand comes increased prices. I look forward to this as well, so I can naturally make money both ways.
Reader Comments (3)
so what is your plan for UNG? -- since you are using it to hedge against high costs in your current natural gas usage....will you be selling off shares to pay for incoming gas bills or hold as an investment based on your speculation of future movement in gas prices?
Would you consider selling call options against a portion of your holdings to generate cash flow and mitigate some of your losses should NG begin to rise faster than your ability to recoup from rents? Also, should UNG spike, rather buying more shares at parabolic prices - possibly sell puts? The tax consequences of the options strategy versus the capital gains income from selling UNG might also be considered?
Carl,
Also some good questions:
I would consider selling call options, however, I am looking at this, first and foremost, as a hedge. So my priorities are not with selling options in order to generate cash flow, but still a strategy to take. In addition, if I thought it was more reasonably priced, I would probably consider that strategy but I do think UNG is quite low currently and would prefer to keep the future gains for me as opposed to selling options for the cash flow.
Second, my current cash flow on the properties as well as on my stock portfolio is pretty decent (4% on the stock/fixed income/cash portfolio), so there isn't a big need for cash flow. I am not able to spend that cash flow on new acquisitions and so it just keeps accumulating along with the cash flow from the real estate.
Finally, from a tax standpoint, the cash flow from the premium of writing options is a short term capital gain, so it can be offset only by short term capital losses. Short term capital gains are taxed, I believe, at the regular income tax rate.
But my question is: if natural gas goes much higher, I can sell off my shares of UNG to offset the losses to my negative cash flow from the properties and the increased natural gas prices.
If you read the book, The Buffetts Next Door, it shows someone who made considerable money employing this exact strategy and I had not even thought about it until you mentioned it just now. I will definitely at least take a look at this and see if there isn't a way to make money off of it.
Paul