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.
You may have heard that the rate of inflation, as measured by the Consumer Price Index (CPI), rose 0.6% in January.¹ Overall, the CPI is up 7.5% since this time last year — a 40-year high, and the largest 12-month increase since February 1982.
Note: most economists still believe inflation will ease this year, as lingering pandemic-related supply chain shortages are hopefully resolved, and more goods become available. It’s also likely the Federal Reserve will increase interest rates to curb the effects of inflation; recent forecasts from Fed officials even suggest three possible rate hikes this year.
That said, many investors wonder whether we have moved beyond a “transitory” trend into an inflationary period, potentially eroding net portfolio returns. These concerns have stoked stock market volatility; the S&P 500 dropped 1.8% following news of the latest CPI report. This uncertainty has also bled into the CRE space, with some investors discussing potential damage to the property sector if persistent price increases drive up long-term interest rates. After all, rising rates lead to higher financing costs, making it more expensive for owners to refinance.
With a higher-inflation environment possible over the next few quarters, 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.
- 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.
- 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.
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.
The Historical Effect of Inflation
Historical data shows that real estate has been somewhat effective as a hedge against inflation. In the chart below, we can see that 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. 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 cash flow to deliver returns are at a disadvantage.
Source: Multi-Housing News, October 2020.
What does this mean for you as a passive investor? Overall, we believe you can expect that the private real estate in your portfolio will fare better amid inflationary challenges. It may be an opportune time to consider rebalancing your portfolio toward private real estate, if you are allocating less than 15%.
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 to deliver strong returns, as values (and hence exit sale pricing) are likely to better keep pace with overall prices in the economy.
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Past performance is no guarantee of future results. The investments discussed herein may be unsuitable for investors depending on their specific investment objectives and financial position. Investors should independently evaluate each investment discussed in the context of their own objectives, risk profile and circumstances.
All opinions expressed herein constitute the author’s judgement as of the date of this article and are subject to change without notice. Statements made are not facts, including statements regarding trends, market conditions and the experience or expertise of author are based on current expectations, estimates, opinions and/or beliefs. Such statements are not facts and involve known and unknown risks, uncertainties and other factors. Past events and trends do not predict or guarantee or indicate future events or results.
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