Real Potential During Inflation

Real estate can help mitigate the corrosive impact of rising prices on portfolios.

Historically, one of the key functions of “real asset” investments was to help keep up with inflation. However, after the rapid price increases of the 1970s, and the following stringent monetary reaction, inflation became close to a non-issue for several decades. That has changed dramatically over the past year, as elevated inflation has moved from a seemingly “transitory” phenomenon to a more stubborn problem, driven by post-pandemic recovery, supply chain issues, worker shortages and supply constraints tied to the Ukraine war. In reaction, the Federal Reserve has curtailed bond purchases and begun to raise ultra-low interest rates toward more neutral levels, which has put pressure on both stock and bond markets, undermining the diversification that has tended to benefit fixed income within traditional asset allocations.

An urgent question for many investors is how to keep up with inflation over time, coupled with the desire to generate income and return potential while seeking to achieve meaningful diversification. In the current climate, we believe that real estate, from both public and private sources, can potentially help manage inflation exposure, as well as address these other needs.

Record of Inflation Resistance

The potential value of real estate as an inflation fighter is clear to us from past results in inflationary environments. Real estate returns have tended to move closely with consumer inflation, while performance has often improved as inflation has accelerated (see displays).

Why Real Estate Can Help Mitigate Against Inflation

Although it’s commonly understood that real estate may help maintain asset value in the face of inflation, the subtleties are sometimes obscured. In a basic sense, real estate makes up a large component of the inflation rate, so one would naturally move with the other. However, the characteristics of the real estate sector are crucial to understanding its potential value in relation to inflation.

Real estate’s inflation-fighting dynamics are largely a result of supply and demand. When construction costs rise, along with commodity prices, wages and other inputs, there are usually two outcomes: The cost of developing new buildings increases, and the price to replace existing buildings increases. A lack of new supply serves to increase demand for existing buildings, typically leading to higher rents. Rising replacement costs support real estate values as both the land and structure generally increase in value. Put simply, most inflationary environments see limited new supply combined with growing demand.

Further, those developers who decide to build despite rising costs usually do so when market rents are rising enough to offset higher costs and maintain development yields on their new properties. Market rent growth also gives owners of existing properties across the same sector room to raise their own rents, especially if that sector tends to have shorter leases and more frequent renewals.

Increasing costs of debt in an inflationary environment can also affect real estate values as most investors use borrowing for a large portion of their purchases. However, this may not be net-negative for return potential: In inflationary environments, rents have tended to increase faster than borrowing costs as rising nominal (beyond the inflation rate) economic growth supports demand; in other words, the same forces driving higher borrowing costs themselves support higher real estate values.

Contractual terms can help support real estate. Shorter-term leases such as at a self-storage facility or the daily rates charged at a hotel can adjust quickly. However, multiyear leases at, for example, an industrial building, an office or retail store may include contractual inflation-linked escalators to protect lessors from this risk. More important than lease duration, however, is pricing power, which is driven by the fundamentals of supply and demand, and may vary sector to sector or location to location.

Accessing the Asset Class

Although direct real estate ownership remains a common way to access the asset class, the segment is fragmented and often inefficient—lending support to the benefits of professionally managed strategies, which we believe can provide diversification and the potential for long-term performance opportunities. Such opportunities are available both in private and public real estate.

Private Real Estate

Private funds focus on an array of specialty areas and disciplines, and may be particularly flexible in seeking to achieve investor goals, whether related to income or capital appreciation. They can generate exposure in areas of particular interest or opportunity, although they typically focus on traditional real estate sectors such as office, industrial, multifamily residential, retail and lodging. Properties and companies that remain private tend to be smaller and less established than public real estate investment trust (REIT) counterparts.

Private real estate funds may be able to operate without the short-term orientation and market turbulence that often affect publicly traded counterparts. They typically have investor qualifications and relatively large investment minimums, although these are easing with the introduction of new investment structures. Private funds also tend to be illiquid for multiyear periods and may require gradual commitments of capital before investors begin to see potential investment returns.

Public Real Estate

Most REITs are publicly traded companies that own, operate or finance real estate. Because of federal tax rules, they are required to distribute the bulk of the income they produce each year. REITs tend to skew toward larger and higher quality. Although originally focused on more traditional sectors, they have expanded to include disruptive business trends (see below). This differentiated sector exposure may complement private real estate strategies in an overall portfolio and diversify away from existing personal property holdings. REIT funds provide exposure to a range of companies to help increase opportunity and manage potential risk. Unlike private counterparts, they are subject to equity market-related volatility, particularly during short-term periods of turbulence. However, over the long term, publicly traded REITs tend to reflect the fundamentals and potential investment returns of the real estate market, independent of equity markets overall (much like private real estate).

Broader Exposure to Growing Sectors

Percent of FTSE NAREI All Equity REITs Index

Source: FTSE Nareit. As of June 30, 2022.

Potential Opportunities and Risks

The current outlook of structurally higher inflation, higher rates, declining growth and geopolitical conflict suggests the potential for persistent market uncertainty. The pandemic introduced long-term impacts on how people work and live that, by extension, could affect the real estate market. Shifts in preferences for working in an office versus at home, or living in urban versus suburban settings, could have lasting effects on geographic markets, real estate cash flows and asset values. Long-term hybrid work arrangements are likely to temper overall demand for office space.

That said, advances in technology, such as 5G cellular and cloud computing, could lead to significant investments in network and information technology infrastructure that benefit data center and infrastructure companies. Moreover, residential sectors may show growth potential due to attractive demographic/demand trends, with family formation by the millennial generation, for example, supporting single-family rentals.

More tactically, strong demand for real estate, combined with limited supply may increase private market values (see display below) even if public securities face headwinds due to broader public market volatility. Several sectors enjoy pricing power, connected to current inflationary and post-COVID trends: Well-located industrial and retail properties are seeing strong demand from tenants, likely driven by better wages and savings; and residential properties are benefiting from rising rents, supported by wages and the rising costs of home ownership. That said, we believe a key guidepost today should be selectivity. Those properties enjoying strong demand, combined with the flexibility to capture price increases, are likely to maintain and grow their value, helping to offset the drain of elevated inflation over time.

Commercial Real Estate Supply Remains Below Historical Levels

Construction Starts as % of Stock

Source: CBRE, Citi. As of 3Q 2021. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

Summing Up

All told, we believe that investors who are concerned about inflation should consider real estate exposure as part of their overall asset allocation. Public real estate securities generally offer a liquid option, with the ability to diversify across a broad range of sectors, including those tied to more innovative, faster-growing parts of the economy. Private real estate can provide significant flexibility and varied income and return characteristics, but also typically carries longer lockup periods and more stringent qualification hurdles than public counterparts. In our view, investors should consider carefully the potential merits of these options and how they, along with other strategies within traditional fixed income and equities, can help address the headwinds created by higher inflation, as well as other issues in today’s uncertain investment climate.

Real Estate Vehicles: Weighing Key Pros and Cons

For illustrative purposes only. This material is general in nature and is not directed to any category of investors and should not be regarded as individualized, a recommendation, investment advice or a suggestion to engage in or refrain from any investment-related course of action. Investing entails risks, including possible loss of principal.