Is real estate a haven from inflation? It depends. Today’s rates may be too high for certain types of real estate to provide a great deal of protection against price increases.
Real estate has a long history as an inflation hedge, based on the principle that income from buildings tends to keep pace with consumer prices. One study by commercial property services firm CBRE found that rents in the UK grew in line with inflation from 1981 to 2020. However, the results have been very mixed depending on the type of property. Of the 14 subsectors in the study, half experienced a decrease in property rents.
Not all investors seem to see defensive property today. Allocations to US real estate equity funds, a guide to sentiment among professional money managers, fell to 2.4%, from 3.1% before the pandemic, according to data from Emerging Portfolio Fund Research. Global allocations also declined. Meanwhile, inflows into publicly traded real estate funds, which are the best proxy for trends among retail investors, are increasing.
Real estate yields the best returns when prices are rising at a moderate pace in response to healthy economic growth. For listed REITs, the ideal rate for inflation is 2% to 3.5%, according to UBS analyst Charles Boissier. Under these circumstances, landlords find it easier to raise rents, while a booming economy creates demand for commercial property and lowers vacancy rates.
However, once inflation rose above 4%, the level the US experienced in April last year and the eurozone in October, some real estate stocks historically struggled to outperform the broader market. It’s hard to hedge against inflation today because it’s driven by more expensive raw materials, labor and energy, which are starting to hurt growth.
The Fed estimates that the economy will grow by 2.8% in 2022, down from the 4% the central bank forecast in December. If the slowing economy reduces the demand for space from tenants, it will be difficult for landlords to raise rents. Rental growth expectations are important because higher interest rates can make it difficult to keep pace with inflation through rising capital.
Recent deals provide clues about the types of real estate stocks that might be a safer bet. Property buyers are most optimistic about housing and logistics, where supply is scarce. In the final quarter of 2021, 45% of all commercial real estate investments in the Americas were in multifamily housing, compared to an average of 28% over the four years leading up to the pandemic, based on CBRE data.
The housing shortage is driving up housing prices in many developed markets, so fewer people can buy and rent. Landlords have managed to increase residential rents in the United States by about 18% over the past two years, according to Redfin data. Real estate investment trusts including American Homes 4 Rent and Invitation Homes have significantly outperformed the S&P 500 since inflation topped 4% at this time last year.
The picture is more mixed in Europe. German residential stocks, including Vonovia and Deutsche Wohnen, which are usually popular with investors, have fallen below the country’s DAX index this year as government regulations determine how much landlords can increase rents.
Vacancy rates are also at record lows for e-commerce warehouses in both Europe and the United States, making logistics resilient. In its first Q1 update, warehouse owner Prologis said he expects rents to increase by about a fifth both in the US and abroad in 2022 thanks to strong demand from tenants.
“There is definitely [other real-estate] says David Grumhouse, president of Duff & Phelps Investment Management. The outlook for some office and retail assets is poor. Landlords with significant exposure to well-supplied office markets like Manhattan and San Francisco will struggle to raise rents as the shift to remote work reduces demand for space. Low-quality malls also have very little pricing power today.
Office and retail REITs in Europe may prove an exception, as commercial rents on the continent are usually inflation-indicated. This gives investors protection on paper, although some analysts are skeptical that owners will be able to enforce the increases. However, large European mall owners Unibail Rodamco Westfield and Kleppiere have posted profits of 10% and 12%, respectively, this year, compared to declines of more than a fifth for US peers Simon Property Group and Macerich..
Historically, European REITs have generated better returns than their peers in other regions during times of high inflation, based on UBS analysis.
Property can provide shelter in times of inflation, but only if supply and demand trends are favourable. Real estate investors should choose the neighborhoods in which they buy.
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