It's a common belief that real assets, like commercial real estate and infrastructure, can help defend against inflation. But, do these assets actually live up to their reputation as reliable inflation protectors?
The past decade has witnessed a period of low inflation and low interest rates. However, this period appears to be coming to an end due to the clear causes of inflation increase, including the impact of COVID and other well-known factors. To address this, central banks have increased their key interest rates, signaling that it is unlikely that inflation will reach its traditional 2% target in the near future.
This begs unpredictability: will central banks continue their rate hikes, and if so for how long? In any case, it is clear that inflationary pressures are here to stay for the time being and investors need to consider diversification strategies that would protect their return from inflation's damaging effects.
Commercial real estate as a hedge against inflation: what does research say?
The question of whether commercial real estate assets truly provide an effective hedge against inflation, as commonly assumed, has been the subject of academic research. In these studies, investors may hope to find an answer to the following interrogations: will real assets maintain their reputation for reliable inflation protection? Or will those who have placed their trust in them find themselves facing diminished returns down the road?
The efficacy of commercial real estate assets as an inflation hedge is generally believed to be strong. However, while some scholars believe that commercial real estate values are more resilient to inflationary shocks than other asset classes, others have argued that the correlation between commercial real estate returns and changes in the inflation rate is weaker than previously thought.
Before diving deeper into this topic, it is worth focusing on valuation theory to point out that commercial real estate values are driven by two components: the net operational income from rents (the “NOI”) and the yield or percentage return required by an investor. For a very basic estimation of market value, one would need to divide a property’s NOI by the market return as illustrated in this simple equation: Value = NOI / yield
Inflation has an opposing effect on value as it impacts both NOI and yield. On the one hand, inflation can have a positive effect on the NOI component of the equation as most rents are reevaluated to compensate for inflation. On the other hand, high levels of inflation generally tend to increase the cost of borrowing, causing a higher yield as it is linked to long-term interest rates, which are usually hiked by central banks in times of high inflation. Among the existing research, a comprehensive piece by Martha S. Peyton published in 20171 states that commercial real estate does indeed provide a hedge against inflation compared to other assets, however, it is not perfect. To be a perfect hedge for inflation, an asset must have a positive 1.00 correlation with inflation. This means that an asset’s return increases at the same pace as prevailing inflation.
Peyton’s work considered data from a US commercial real estate index between 1978 and 2011. She found that commercial real estate has a positive, yet imperfect, correlation with inflation of 0.38. While this correlation might not be as strong as initially thought, it is higher than the correlations provided by other investments, such as the S&P 500, treasuries and corporate bonds.
Peyton’s work also zeroes in on different asset classes within commercial real estate and how their NOI growth is correlated with inflation. She finds that NOI growth in the purpose-built residential sector has a higher correlation with inflation than NOI in the office sector. This can be attributed to the fact that residential leases tend to be short term (on average 12 months) and can be renegotiated at expiry. Leases for office space, on the other hand, tend to be multi-year and may not have adequate indexations built in.
Location is key, but preparation is crucial
In practice, local market conditions and government regulations also have a strong effect on real estate’s correlation with inflation. For instance, a purpose-built residential asset is going to offer very limited inflation protection if the local government has instituted a freeze on rent increases as we’ve seen in some markets during the COVID-19 pandemic.
On the contrary, if an office building is located in a market where landlords have higher bargaining power due to a shortage of available space, landlords will be able to command higher rents and build in indexation mechanisms to protect themselves from increasing inflation.
In the Luxembourg market especially, commercial real estate generally exhibits a positive correlation to inflation due to its ability to capture value through rent increases, which can act as a buffer against inflationary pressures. Nevertheless, every investment decision and investment has its own characteristics and it is important to note that commercial real estate investments are far from foolproof when it comes to guarding against inflation. Commercial real estate returns can be volatile and may not always provide protection against inflationary shocks due to local-market factors. Therefore, while commercial real estate may serve as part of an effective diversified portfolio with an eye towards inflation protection, investors should not expect it to be a panacea for inflationary risk.
To make the most informed decisions as is possible when it comes to diversifying portfolios through commercial real estate, investors should seek out experts who not only understand these types of assets, but who also have a deep knowledge of local markets within which these investments are operating. By doing so, they can ensure that their portfolio has sufficient exposure to the right mix of commercial real estate assets.
“For successful investments in an uncertain and rapidly changing environment, preparation is key. EY Luxembourg assists investors with navigating the specificities of each opportunity and making reasoned decisions thanks to a multidisciplinary team of trusted transaction advisors specialized in valuation, due diligence and corporate finance,” comments Christophe Vandendorpe, Strategy and Transactions Leader at EY Luxembourg.
