CRE as an Inflation Hedge Is More Nuanced Than Many Realize

Inflation continues to soar and investors—from the consumer/retail level to the biggest family office, investment, public pension, and sovereign wealth funds—are on the hunt for hedging.

Commercial real estate has long been seen as a natural inflation hedge, but automatic assumptions need some reconsideration.

“It has been decades since we have seen an extended period of high inflation,” Drew Thornfeldt, managing director and global head of real estate investment banking at Chatham, tells GlobeSt.com. “Since that time, the real estate market has changed dramatically—shifting to a global institutional asset class. Data for real assets typically lags other asset classes, and since there have only been a few quarters of elevated inflation, it is challenging to draw decisive conclusions on real estate’s effectiveness to hedge inflation in general.”

Thornfeldt goes on to note that, anecdotally, both “cash flow and valuation growth in institutional real estate has been strong and would indicate segments of the real estate market effectively provide direct exposure to inflation.” But there’s also a danger in assuming everything CRE will necessarily act the same.

That’s the conclusion a new analysis by Avison Young comes to, as the firm expects “a period of higher inflation and interest rates than we have been used to in recent years.” Pressures from labor and skills shortages, increases in wages, ongoing if moderated supply chain disruptions, and capacity constraints will continue to fuel inflation that will peak in Q2 of 2022 but still remain above the 2% target of central bankers until next year.

In theory, Avison Young notes, real estate should be a good inflation hedge. However, like many theories, what might happen on average doesn’t necessarily hold true in all situations. For example, statistical relationships between total returns and inflation are weak because “the relationship between property performance and inflation depends on the state of the market as well as the type of inflation involved.”

For CRE to act as a credible general inflation hedge, investment times should be across longer terms and not necessarily as a short-term tool. “To guarantee positive real returns over their hold period, over the last 35 years office investors should have targeted a 9-year investment horizon for the UK, 10-year for Canada and 13-year for the US,” the report says.

The company also says that in the type of short-term inflation over the next few years, there are some sectors that work better. Short-term leases; multifamily, student, and industrial; and triple-net leases. 

“Returns from core real estate assets are mainly driven by income (which is more closely linked to inflation) than capital growth (which is vulnerable in a rising interest rate environment),” the company writes. “Moreover, rising construction and labor costs (typical in an inflationary environment) render development activity less financially feasible. As a result, prime centrally located office assets, for example, with state-of-the-art technology and sustainability credentials become scarce and more sought after by investors as well as tenants.”

Moody’s Analytics also has a view in a new report. The thesis is that while CRE can be a weapon against inflation, some assets are “a double-edged sword.” There has to be enough demand to push rent growth. If cap rates or loan coupons are too tightly priced, that can choke any advantages. Also, the efficacy depends on an overall debt position that may not sufficiently benefit from rent growth and at the same time expose investors to higher than expected losses from refinancing rates.