Real Estate Inflation Hedge: An Overview

October 27, 2022
By EQUITYMULTIPLE Staff
investing in alternatives
Posted In: Market Commentary

A version of this article was originally published on February 28, 2018.

“Alternatives and Private Real Estate in particular have strong historical support for hedging capabilities against inflation. In an environment where the focus tends to be on headline or CPI inflation and how that is slowing down, I would rather place the focus on Core Inflation (CPI Inflation minus food/energy prices)—which hit a 40-year high in the last month—and which has historically been the focus of the Fed.

With inflation having a more protracted and widespread impact, and continued market volatility, a longer-term allocation to Alts makes a lot of sense.”

– EquityMultiple’s Charles De Andrade, CAIA,
Associate Director of Investments

By now, you’ve likely heard the Federal Reserve plans to raise interest rates by another 0.75% next month as part of their continued effort to curb inflation.1 For context, the Consumer Price Index (CPI) increased 0.4% in September, and is up 8.2% from this same time last year.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 recently noted “The longer the current bout of high inflation continues, the greater the chance that expectations of higher inflation will become entrenched.”1

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.3
  • 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.4

real estate asset class performance in inflationary environments: effect of a 1% increase in inflation on NOI

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.4

growth in property value vs inflation: effect of a 1% increase in inflation on property value (1979-2020)

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.5 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.

Average annual rates of inflation and rent growth, demonstrating how CRE serves as a hedge against inflation

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.3 

Conclusion

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.

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1https://www.nytimes.com/2022/10/18/business/economy/federal-reserve-inflation-november-meeting.html

2https://www.bls.gov/news.release/pdf/cpi.pdf

3Source: Alternative Investments: CAIA Level II, Chapter 14: Real Estate as an Investment, October 2016

4Source: 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

5Source: PGIM Real Estate, 2022 Global Outlook: Investing Through Uncertainty, May 2022

https://cdn.pficdn.com/cms/pgim-real-estate/sites/default/files/GlobalOutlook2022_final.pdf

*https://www.multihousingnews.com/post/rental-prices-can-hinder-inflation-report/

*https://www.wsj.com/articles/commercial-real-estate-is-seen-as-an-inflation-hedge-but-that-isnt-always-the-case-11645534801?mod=hp_major_pos1#cxrecs_s

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