Aspiriant | Insight April 2011 | Volume XVIII No. 1.4

Real Estate...An Inflation Hedge?

Allocation to real assets can play an important role in a longterm investment portfolio and, in particular, as a hedge against inflation risk.

Assets that are tangible or physical in nature encompass a wide range of investment strategies whose values are sensitive to inflation. Examples of real assets represented in Aspiriant portfolios include real estate and commodities. Commodities were added to Aspiriant portfolios several years ago in particular to provide significant and unique protection against inflation. Similarly, real estate has demonstrated that it is a good, albeit partial hedge against inflation. The reasons why are fairly simple.

First, inflation causes a rise in construction costs, which, in the short run, will limit new supply. Why is this the case? Because real estate developers/investors target a certain return on cost (yield) prior to starting a new development. If the numerator (net operating income derived from rents less expenses), does not rise sufficiently to offset an increase in the denominator (development costs), then groundbreaking on new projects will be postponed until projected net operating income rises enough to meet the desired yield.

Inflation, then, fuels rent growth and, as a result, an increase in value of existing properties.

Although inflation will drive up expenses as well, many commercial real estate leases are structured so that the tenants bear all expense increases, insulating property owners from much of the burden of higher expenses.

The combination of these factors translates into higher market rents, which eventually feed higher operating incomes. In some real estate sub-asset classes such as hotels and apartments, which generally have shorter lease terms, the impact can happen relatively quickly. In others, with longer average lease terms such as retail and office properties, it may take longer for the impact to filter through. However, real estate investors will often price in the expectation of future rent increases, and will give existing owners “partial credit” for this expectation in their current valuation of properties, even if the rent increases haven’t materialized for that property quite yet. This occurs by a fall in the capitalization rate (or yield, calculated by the net operating income divided by the property value) used to value a property. Essentially, investors lower the discount rate they are using to value existing cash flows, resulting in a higher estimated property value.

Why, then, is commercial real estate considered only a partial hedge against inflation? The reasons are a bit more complicated and have to do with the condition of the space markets, real estate’s sensitivity to interest rates, and how real estate is owned (direct private ownership or through a securitized vehicle such as a REIT).

One clear lesson from the early 1990s is that owning real estate is not an effective hedge against inflation if there are large oversupplies of space in property markets. High vacancies inhibit a landlord’s ability to lift rents, while expenses might respond more immediately. During this period of time, even though consumer prices rose steadily, commercial property prices collapsed. In contrast, from 1979 to 1982 (a period of high inflation, peaking at 15%, and a relatively healthy space market measured by the vacancy rate), commercial real estate outperformed, returning 17% vs. stocks and bonds, returning approximately 11% and 6%, respectively. Unlike the collapse in the early 1990s caused by massive overbuilding, additions to new supply over the last ten years have been relatively moderate. As a result, today’s space markets are not as vastly oversupplied as in the early 1990s. In many cities, landlords have already begun to raise rents as job growth has resumed. If inflation were to rise significantly (which we don’t expect), we’d expect this impact to amplify.

A second reason why real estate may act only as a partial hedge is that commercial real estate is impacted by interest rates, as most acquisitions are at least partially financed by debt. Higher interest rates will affect the price a buyer is willing and able to pay to meet its required rate of return, thereby dampening real estate value increases.

Source: S&P; Barclay’s Capital; NAREIT; NCREIF: Moody’s; PPR

Lastly, academic research has indicated that while privately held commercial real estate over the period of 1978-2009 provided an excellent hedge for inflation, REITs have not been an effective inflation hedge, especially against unexpected inflation. While theories abound to explain the performance of REITs during inflationary periods, it is important to note that until the mid 1990s, the REIT industry was dominated by mortgage REITs, which provide debt financing for commercial or residential properties. Like bonds, mortgage REIT values are negatively impacted by rising interest rates. The rise of equity REITs (REITs that own and operate properties) occurred after the passage of the Tax Reform Act of 1986. Today, equity REITs represent over ninety percent of Aspiriant clients’ REIT exposure. The research done to date on equity REITs performance during inflationary periods has been inherently limited by the fact that since the mid 1990s, inflation has never exceeded 3.85% in the US. More recent research on equity REITs seems to indicate a positive correlation with inflation, while mortgage REITs have a significant negative correlation with inflation. As we’ve seen with the extreme price volatility over the last few years, REIT performance can be affected as much or more by general stock market sentiment than underlying property valuations. Nevertheless, although REITs’ ability to act as an inflation hedge may be dampened in comparison to privately owned real estate, we do expect equity REITs to exhibit an increasingly positive correlation to inflation particularly in periods of aboveaverage inflation growth.

Consequently, if we do face an inflationary period, we expect commercial real estate owned by our clients, whether privately or through REITs, to provide a valuable inflation hedge in their investment portfolios.

Lauren Pressman
Director - Investment Research, Real Estate

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