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.”
This article was originally published on February 28, 2018.
You may have heard that inflation, as measured by the Consumer Price Index (CPI), rose 0.4% in February, after rising 0.3% in January. Overall, the CPI is up 1.7% since February, 2020. While this is in line with economists’ expectations, many individual investors wonder whether this trend is transitory, or if it will lead to a period of high inflation, and potentially erode net portfolio returns.
There’s no doubt that the COVID-19 pandemic has (at least temporarily) changed consumer spending habits. For instance, over the past year, consumers have spent less on transportation, hotels, and recreation, and spent more on groceries and beverages. But as more states begin to reopen, and Americans spend their stimulus money, demand may shift. This pent-up demand will likely cause prices to increase.
With a higher-inflation environment possible over the next few quarters, it’s a good time to revisit how private real estate investing provides a hedge against inflation. Here are a few considerations for real estate investors in a high-inflation 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 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: real estate can reliably provide a hedge against inflation, 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, the value of an existing property 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 may still fare better than others. In times of high inflation, longer-term projects that rely heavily on cash flow to deliver returns are at a disadvantage.
Sources: Bureau of Labor Statistics, FRED, American Housing Survey. Image courtesy of Multifamily-Housing News and Middleburg Communities.
What does this mean for you as a passive investor? Overall, you can expect that the private real estate in your portfolio will fare better amid inflationary challenges. It may be an opportune time to rebalance 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. As the historical data suggests, you may want to give preference to investments that do not rely too heavily on interim rental cash flow 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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