How Private Real Estate Serves as a Hedge Against Inflation
“Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.”
A version of this article was originally published on February 28, 2018.
By now, you’ve likely heard the Federal Reserve raised interest rates by 0.75% for the second time this summer in an effort to curb inflation.1 For context, the Consumer Price Index (CPI) increased 9.1% on a yearly basis in June, the largest 12-month increase since the period ending November 1981.2 Of course, the question on everyone’s minds is: how long will we remain in this period of higher inflation? Even Fed Chairman Jerome Powell noted that while he does not believe we are currently in another recession, “another unusually large (rate) increase could be appropriate” when the Fed next meets if inflation does not significantly slow.3
Given the current macroeconomic climate and recent stock market volatility, we think it’s a good time to revisit how private real estate investing can provide a hedge against inflation. Here are a few considerations for real estate investors in an inflationary environment:
Rents Can Rise With Prices
While the net returns of bonds, stocks, and fixed-rate vehicles stand to take a hit as inflation rises, real estate managers can mitigate the effect of inflation by raising rents at managed properties. Of course, this does not occur uniformly across properties, property types, or markets. Can you recall having a landlord that seemed oblivious to the forces of inflation, leaving you with a screaming deal on rent? Indeed, it takes a bit of foresight to effectively combat inflation.
Here are some techniques commercial real estate operators use to mitigate the risk of rising inflation:
- CPI Indexation: Contractually tethering rent increases to upward movements in the CPI. While this may sound overly bureaucratic, it was fairly standard in the ‘70s and ‘80s, when inflation was more prevalent. Many long-term commercial real estate leases today still contain an escalator clause, which periodically adjusts lease payments based on some agreed upon measures of inflation.4
- Periodic rent reviews that are built into leases. This is particularly important with longer-term leases, and/or when few or only one tenant occupies the property. Multifamily or self-storage landlords, for instance, typically ask their tenants to sign short-term leases, and can raise rent for each unit on an annual basis (or whenever there is turnover), giving them more flexibility to account for inflation.
- Shifting operating and capital improvement costs to tenants: Sponsors may be able to shift some of the costs of improving and operating a property to tenants. In particular, materials, services, and utilities are likely to move alongside inflation. While this shift may require lowering gross rents to stay competitive in leasing, it can make a large impact on net operating income (NOI) over longer leases. Note: this applies to non-residential CRE asset classes: industrial, retail, and office.
The bottom line: we believe real estate can reliably serve as an inflation hedge, but only if managed well. As a passive real estate investor, you may want to ask if the sponsor has a plan for growing NOI at pace with inflation so that returns are not watered down over time. Worth noting: the Pension Real Estate Association (PREA) recently published an analysis indicating that between 1979 and 2021, the net operating income of all properties increased 0.5% for every 1% increase in inflation, with shorter-leased real estate sectors such as apartments able to capture more inflation-driven growth.5
Real Estate Holds Intrinsic Value
Real estate holds intrinsic value because it is scarce. Particularly in dense, urban neighborhoods, there may be a limited supply of properties, and a lack of available land to build new structures on. This is good news for current property owners, as demand for real estate does not generally decrease, even when inflation rises. In fact, property values might increase, given the rising cost of materials and labor to build a comparable structure. Note: the same study from PREA found a strong relationship between growth in property value and inflation, with office buildings and apartment values gaining 1.2% and 1%, respectively, for each 1% increase in inflation (see below). Industrial assets also posted gains in value.5
The Historical Effect of Inflation
Historical data shows that real estate has been somewhat effective as a hedge against inflation. On a global scale, real estate in the past 40 years has had exactly 0% real rental rate growth, signaling a perfect hedge with inflation.6 In the chart below, we can see that U.S. multifamily is fairly resilient, and has provided at least a partial hedge against inflation. This was true even in the 1970s and 1980s, when inflation was at a record high due to low job growth and high unemployment.
Source: Multi-Housing News, October 2020.
That said, some asset classes and investment strategies may still fare better than others (one reason we prize diversification at EquityMultiple). In times of high inflation, longer-term projects that rely heavily on locked-in, unadjustable leases and cash flow to deliver returns are at a disadvantage. Investors in real estate equity that are leveraged with adjustable-rate mortgages may also suffer from higher financing costs during times of inflation.4
Where does this leave you as a passive investor? Overall, we believe you can expect that the private real estate in your portfolio, as an alternative investment and real asset, will fare better amid inflationary challenges when compared to traditional stock and bond investments. As such, it may be an opportune time to consider rebalancing your portfolio to include private real estate.
With respect to individual real estate projects, it’s worth examining whether a sponsor has a plan to mitigate the effect of inflation on NOI, particularly in the case of a long hold with substantial rental cash flow. You may want to give preference to investments that do not rely too heavily on interim rental income that is locked in/unadjusted over time to deliver strong returns, as values (and hence exit sale pricing) are likely to better keep pace with overall prices in the economy.
Build a more diversified portfolio with EquityMultiple. Contact Investor Relations or sign up to create your free account today.
4Source: Alternative Investments: CAIA Level II, Chapter 14: Real Estate as an Investment, October 2016
5Source: Columbia Threadneedle Investments, 7/13/22 https://www.columbiathreadneedleus.com/binaries/content/assets/cti-institutional/insights/blogs/how_does_real_estate_perform_in_inflationary_environments.pdf
6Source: PGIM Real Estate, 2022 Global Outlook: Investing Through Uncertainty, May 2022
This material is confidential and has been prepared solely for the information of the intended recipient and may not be reproduced, distributed, or used for any other purpose or shared with anyone in any form or format. This has been prepared for you by EM Advisor, LLC (“EM”), an SEC registered investment advisor. Information within this report may have been provided by third-parties and, while EM believes this information to be accurate, EM has not independently verified such information. Reference to registration with the Securities and Exchange Commission (“SEC”) does not imply that the SEC has endorsed or approved the qualifications of the firm or its respective representatives to provide any advisory services described on the report or that the Firm has attained a level of skill or training. Investments in securities are not FDIC insured, are not bank guaranteed and may lose value. Investing in securities involves risks, and there is always the potential of losing money when you invest in securities.
Additionally, investments may not achieve stated social, environmental, or similar objectives. Before investing, consider your investment objectives and EM charges and expenses. EM advisory services are designed to assist clients in achieving discrete financial goals. They are not intended to provide financial planning with respect to every aspect of a client’s financial situation, they do not incorporate investments that clients hold elsewhere, and they do not provide tax advice. Past performance does not guarantee future results, and the likelihood of investment outcomes are hypothetical in nature. Nothing in this presentation constitutes an offer, solicitation of an offer, or advice to buy or sell securities in jurisdictions where EM is not registered.
EM’s Form ADV can be found here: https://adviserinfo.sec.gov/firm/summary/314402.
Was this content useful?
We'd like to hear from you. Your feedback will help us provide new material that is useful to you.