Commercial real estate is commonly thought of as an asset class that is a good hedge against inflation. Some characteristics that make commercial real estate an attractive investment to protect investors against inflation are long holding periods, operating income during hold periods, lease structures that have built-in clauses for rent escalations, and the limited supply that doesn’t exactly keep up with population growth. While all these reasons make a good case for real estate investments to hedge inflation, real estate is by no means an end-all be-all protection against inflation.
Real estate is a very broad asset class and can not be looked at as one type of investment. Instead, to use real estate as protection against inflation, investors must take a look at the specific asset classes of real estate to determine the best hedge against inflation. Commercial real estate brokerage Berkadia released a research report introducing a metric called Inflation ß which measures the sensitivity of returns to changes in inflation rates. Through this metric, Berkadia analysts found that in times of high inflation, privately owned commercial real estate performed better than equity REITs and stocks. One potential explanation for this is that the illiquid nature of privately owned commercial real estate protects the asset values better during inflationary periods. As depicted by the following graph, the Berkadia Report used a Sortino Ratio (a measure of risk-adjusted performance) to determine which real estate assets performed the best in different economic environments. The research found that real estate asset classes such as multifamily and industrial have stronger risk-adjusted performances during inflationary periods than other real estate asset classes. Short-term leases in apartments allow for rent increases that provide a safe hedge against inflation. Industrial has been a safe hedge against inflation because of the strong demand for infrastructure in our rapidly growing supply chain. These reports tell us that the most pragmatic strategy for real estate investing especially in times of inflation is to always measure investments on a risk-adjusted basis. While multifamily and industrial tend to outperform other asset classes on a risk-adjusted basis, in periods with no inflation, other riskier asset classes such as retail and hotel may be worth the potential higher returns.
With the Fed signaling that interest rates are likely to rise significantly in 2022, how will real estate investment strategies adapt to maximize returns during an inflationary period?
Navigating the complexities of real estate investments, especially in times of inflation, requires a nuanced approach. The idea that commercial real estate can act as a hedge against inflation is sound, given factors like long holding periods and rent escalation clauses. However, it’s crucial to recognize that real estate is not a one-size-fits-all solution.
The concept of Inflation ß introduced by Berkadia sheds light on the varying performance of different real estate asset classes during inflationary periods. Privately owned commercial real estate, particularly in multifamily and industrial sectors, appears to offer stronger risk-adjusted performances due to factors like short-term leases allowing rent adjustments and the growing demand for infrastructure in supply chains. These findings emphasize the importance of evaluating investments based on a risk-adjusted basis.
As the Federal Reserve signals potential interest rate hikes, adapting real estate investment strategies becomes paramount. Investors must remain vigilant, considering the specific dynamics of different asset classes to maximize returns while navigating the challenges posed by inflationary periods.