“Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.”
Recent swings in the market have been driven primarily by fear of inflation: that the The Fed will be forced to more aggressively pursue rate hikes throughout the year, pushing up interest rates, making borrowing more costly, and impacting corporate profits.
These fears may or may not be well-founded. The CPI (Consumer Price Index – the Bureau of Labor Statistics’ primary gauge of inflation) rose 2.1% in January, a slight uptick to the price growth figure year-over-year. While economists generally believe inflation is not problematic for the economy below 3% annual growth, there is potential for greater inflation in the coming months: the recently-signed tax reform bill will almost certainly increase the national deficit, and history shows that further growing the national debt at full employment tends to spur inflation. Meanwhile, The Fed is breaking in a new Chairman, and Jerome Powell’s attitude toward combating inflation is somewhat unknown.
Mr. Powell made his first public appearance on 2/27, testifying before the House Financial Services Committee, and suggested he will prioritize sustained growth while hewing closely to his predecessor’s policies. While the new Fed Chair practiced the equivocation typical of such remarks, he did seem to suggest that growth would be prioritized over combating inflation.
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 the effects of inflation, and further 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 effects of inflation on net returns by periodically and systematically 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 specific techniques leveraged by commercial real estate operators to mitigate for the risk of inflation:
- CPI Indexation: Contractually tethering rent increases to upward movements in the CPI (Consumer Price Index). 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 and managers may be able to shift some of the capex costs associated with improving and continually operate a property to the tenants. These capex costs – materials, services, and utilities – are likely to move alongside overall inflationary trends in the economy. While this shift may require lowering gross rents to stay competitive in leasing, it can make a large positive impact on net operating income, particularly 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, it may be worth asking if the sponsor on a given project has a plan for growing NOI at pace with inflation so that returns are not watered down over time.
Historical data shows us that real estate has been somewhat effective as a hedge against inflation. Comparing movements in net income and value for major commercial asset classes to CPI – for 38 years ending in 2016 – shows that CRE has provided at least a partial hedge against inflation with respect to income (other than office) and that values have fared better against inflation that income across the board. One conclusion from these data: in times of high inflation, longer-term projects that rely heavily on cash flow to deliver returns are at a disadvantage.
What does this mean for you as a passive investor in commercial real estate? 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 on a given project has a plan in place to mitigate the effects of inflation on NOI, particularly in the case of a long hold with substantial rental cash flow. As the historical data suggests, it may be worth giving preference to those investments that are not too heavily reliant on interim rental cash flow to deliver strong returns, as values (and hence exit sale pricing) is likely to better keep pace with overall prices in the economy.