Is real estate protected from inflation? It depends. Today’s rates may be too high for some property types to provide enough protection against rising prices.
Real estate has a long history as an inflation hedge, based on the principle that income generated from real estate tends to keep pace with consumer prices. A study by commercial property services company CBRE found that rents in the UK rose in line with inflation from 1981 to 2020. However, the results were very mixed depending on the type of property. Of the 14 real estate sub-sectors studied, half experienced a decline in real rents.
Not all investors seem to view real estate as defensive today. U.S. equity fund allocations to real estate, a guide to professional fund manager sentiment, fell to 2.4% from 3.1% before the pandemic, according to data from Emerging Portfolio Fund Research. Global allocations also fell. At the same time, inflows into listed real estate funds, the best indicator of the attitude of retail investors, are increasing.
Real estate generates the best returns when prices rise at a moderate pace in response to healthy economic growth. For listed real estate investment funds, the inflation sweet spot is 2% to 3.5%, according to UBS analyst Charles Boissier. Under these conditions, landlords find it easier to raise rents, while a buzzing economy creates demand for commercial properties and lowers vacancy rates.
However, once inflation rises above 4%, a level the US surpassed in April last year and the Eurozone in October, some real estate stocks have historically struggled to outperform the broader market. . Today’s inflation is difficult to hedge as it is driven by more expensive commodities, labor and energy, which is starting to hurt growth.
The Fed estimates the economy will grow 2.8% in 2022, down from the 4% forecast by the central bank in December. If a weaker economy reduces tenant demand for space, it will be difficult for landlords to raise rents. The outlook for rental growth is important because higher interest rates can make it harder for capital appreciation to keep up with inflation.
Recent deals provide clues about the types of real estate stocks that might be a safer bet. Property buyers are most optimistic for residential and logistics, where supply is limited. In the last quarter of 2021, 45% of all commercial real estate investment in the Americas region was in multi-family housing, compared to an average of 28% in the four years before the pandemic, according to data from CBRE.
A housing shortage is pushing up house prices in many developed markets, so fewer people can afford to buy and need to rent. Landlords have been able to raise US residential rents by about 18% over the past two years, according to data from Redfin. REITs, including American Homes 4 Rent and Invitation Homes, have largely outperformed the S&P 500 since inflation topped 4% at the same time last year.
The picture is more mixed in Europe. German residential stocks, including Vonovia and Deutsche Wohnen, generally popular with investors, have lagged the country’s DAX index this year as government regulations limit the amount landlords can raise rents.
Vacancy rates are also at historic lows for e-commerce warehouses in Europe and the US, which should make logistics resilient. In its first quarter update, warehouse owner Prologis said it expects to increase rents by about a fifth in the United States and abroad in 2022 thanks to strong demand from tenants.
“There is certainly [other real-estate] sectors that won’t benefit…because they don’t have the levers to pull to fight inflation,” says David Grumhaus, president of Duff & Phelps Investment Management. The outlook for some office and retail assets is poor. Landlords who are heavily exposed to oversupplied office markets such as Manhattan and San Francisco will struggle to raise rents as the shift to remote working reduces demand for space. Poor quality malls also have very little pricing power today.
European office and retail REITs may be an exception, as commercial rents on the continent are generally indexed to inflation. This gives investors protection on paper, although some analysts are skeptical of the ability of owners to impose increases. Still, major European shopping center owners Unibail Rodamco Westfield and Kleppiere have gained 10% and 12% respectively this year, compared with falls of more than a fifth for their US counterparts Simon Property Group and Macerich..
Historically, European REITs have generated better returns than their counterparts in other regions during times of high inflation, according to analysis by UBS.
Real estate can provide shelter in times of inflation, but only if supply and demand trends are favourable. Real estate investors should be selective about the neighborhoods in which they buy.
Write to Carol Ryan at carol.ryan@wsj.com
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