Is real estate a haven from inflation? It depends. Today’s rates may be too high for certain types of property to offer much protection against rising prices.
Real estate has a long history as an inflation hedge, based on the principle that income generated by buildings tends to keep pace with consumer prices. One study by commercial real estate services firm CBRE found that rents in the U.K. grew 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 subsectors in the study, half experienced a fall in real rents.
Not all investors appear to see property as defensive today. U.S. equity fund allocations to real estate, a guide for sentiment among professional money managers, have fallen to 2.4%, from 3.1% before the pandemic, according to data from Emerging Portfolio Fund Research. Global allocations have also dipped. Meanwhile, inflows into listed real-estate funds, a better proxy for attitudes among retail investors, are increasing.
Real estate generates the best returns when prices are increasing at a moderate pace in response to healthy economic growth. For listed real-estate investment trusts, the inflation sweet spot is 2% to 3.5%, according to UBS analyst Charles Boissier. Under these conditions owners find it easier to raise rents, while a humming economy creates demand for commercial property and lowers vacancy rates.
However, once inflation rises above 4%, a level that the U.S. passed in April last year and the eurozone in October, some real-estate stocks have historically struggled to outperform the wider market. Today’s inflation is tricky to hedge because it is driven by more expensive raw materials, labor and energy, which is beginning to hurt growth.
The Fed estimates the economy will grow by 2.8% in 2022, down from the 4% the central bank predicted in December. If a more sluggish economy reduces demand for space from tenants, it will be difficult for landlords to raise rents. The outlook for rent growth is important as higher interest rates may make it harder to keep up with inflation through capital appreciation.
Recent deals provide clues about which types of real-estate stocks may be a safer bet. Property buyers are most bullish about residential and logistics, where supply is tight. In the last quarter of 2021, 45% of all investment in commercial real estate in the Americas region was in multifamily housing, compared with an average of 28% over the four years before the pandemic, based on CBRE data.
A housing shortage is pushing up home prices in many developed markets, so fewer people can afford to buy and must rent. Landlords have been able to increase U.S. residential rents by around 18% over the past two years, according to Redfin data. REITs including American Homes 4 Rent and Invitation Homes have significantly outperformed the S&P 500 since inflation breached 4% this time last year.
The picture is more mixed in Europe. German residential stocks including Vonovia and Deutsche Wohnen, usually popular with investors, have lagged the country’s DAX index this year as government regulations cap how much landlords can increase rents.
Vacancy rates are also at record lows for e-commerce warehouses in both Europe and the U.S., which should make logistics resilient. At its first-quarter update, warehouse owner Prologis said it expects to raise rents by roughly a fifth in both the U.S. and overseas in 2022 thanks to strong tenant demand.
“There are definitely [other real-estate] sectors that won’t benefit…because they have no levers to pull to combat inflation,” says David Grumhaus, president of Duff & Phelps Investment Management. The outlook for some office and retail assets is poor. Landlords that have high exposure to oversupplied office markets such as Manhattan and San Francisco will struggle to raise rents as a shift to remote work reduces demand for space. Low-quality shopping malls also have very little pricing power today.
European office and retail REITs may prove an exception, as commercial rents on the continent are usually indexed to inflation. This gives investors protection on paper, although some analysts are skeptical that landlords will be able to enforce rises. Still, Europe’s big shopping mall owners Unibail Rodamco Westfield and Kleppiere have gained 10% and 12%, respectively, this year, compared with falls of over a fifth for U.S. counterparts Simon Property Group and Macerich. Historically, European REITs have delivered better returns than peers in other regions during times of high inflation, based on a UBS analysis.
Property can provide shelter in inflationary times, but only if supply and demand trends are favorable. Real estate investors should be choosy about the neighborhoods they buy in.
Write to Carol Ryan at carol.ryan@wsj.com
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