How real estate may serve as a hedge against inflation

Q1 2022 With inflation at a 40-year high, many investors are focusing on how their investment portfolios will be impacted. Recently, we have engaged in numerous conversations with investors and other market participants where the dominant topic is inflation. And that makes sense because real estate is typically viewed as a hedge against inflation. Inflation erodes purchasing power and increases the probability of recession as the monetary policy of increasing interest rates dampens economic growth. In this Viewpoints, our quarterly installment that addresses our perspectives on topics of interest, we share our thoughts on the causes of the current inflationary environment, how real estate may act as an inflation hedge, and how Chestnut’s investment strategy is influenced by this. In subsequent quarters we’ll dive into other market and macroeconomic issues such as the correlation between interest rates and real estate returns. 

When we founded Chestnut Funds in 2012, our investment thesis was that opportunity existed in the middle market space to manage funds in an institutional manner but with a focus on assets that typically did not attract institutional capital. We focused on property types that we had first-hand experience with - office, retail, industrial, and medical outpatient properties. We remain true to this founding investment thesis today.  

A few reasons for rising inflation

Following the Great Financial Crisis in the late 2000’s, many commentators and economists expected to see a significant inflation increase spurred by the fiscal and monetary stimulus measures used to bolster the financial system and provide relief for workers and consumers. That expected inflation increase didn’t occur, with the most convincing explanation being, in our opinion, that there was a general lack of demand for goods and services. Without robust demand, rising prices typically don’t take hold. 

From our perspective, what did occur from the monetary stimulus measures was a steady and sustained increase in asset values driven in large part by historically low interest rates. These low interest rates ultimately increased leveraged returns but also resulted in low interest rates paid on savings, spurring many investors to invest in riskier assets.  

In our view, the current inflationary situation, experienced in the wake of the pandemic, is a function of several factors.  

Central bank stimulus: The Federal Reserve has maintained an expansionary monetary policy of low rates and asset purchases even as inflation has increased, suggesting acceptance of higher inflation than the Fed’s target of 2%. Interest rate hikes have begun, though. 

Fiscal stimulus: The US and most developed economies saw significant fiscal stimulus at the beginning of and throughout the pandemic to mitigate the impact of unemployment and to bolster demand for goods and services. 

Demand Surge: Once economies began to re-open following pandemic lockdowns, demand, fueled in part by fiscal stimulus, increased significantly. US consumers have saved $2 trillion and are now spending those savings on a host of goods and services.  

Supply chain constraints: Logistical challenges along with increasing production costs have served to decrease supply, a challenging dynamic in a high demand period. The war in Ukraine is serving to further exacerbate supply challenges. 

Real estate as an inflation hedge

We believe that real estate portfolios can serve to provide protection against the effects of inflation. In general, we have found that real estate values tend to increase over time at a rate equivalent to or faster than inflation.  

Furthermore, we believe real estate has a relatively low correlation with other investment options such as stocks and bonds. Some of the ways in which real estate can serve as a hedge against inflation are outlined below. 

Increasing income: Commercial real estate values are a function of properties’ income. To the extent that inflation results in increased wages and incomes, tenants can afford higher rents. Higher rents in turn lead to increased property income and cash flow. 

Leverage: By and large, real estate investments are leveraged. With leverage comes risks but also presents opportunities to drive returns. While debt costs remain fixed prior until debt maturity (except in the case of floating rate debt), increasing property incomes serve to increase leveraged returns at a faster rate than unleveraged income growth. Furthermore, increasing values fueled by increased property income has a deleveraging effect, reducing loan-to-value ratios. 

Contractual rent increases: Long term leases tend to have contractual annual rent increases throughout the lease term. Many leases are structured with fixed annual increases, but we expect to see more leases where escalations are tied to increases in CPI. Furthermore, many leases obligate tenants to pay some portion of property operating expenses, providing further protection against operating cost increases. And in instances where there isn’t a rental escalation, at the end of the lease term real estate owners may be able to increase rents. 

Higher costs for construction: Real estate owners benefit from increasing construction costs as higher costs tend to limit new development, reducing the supply of new and competitive space. Offsetting this benefit, of course, is that higher costs negatively impact costs related to capital improvements. 

Portfolio positioning in times of inflation 

While we find that real estate in an investment portfolio in general can act as a hedge against inflation, all real estate investment doesn’t respond in the same way during times of inflation. We believe several factors are important to bear in mind when considering real estate investments.  

Limited supply: Much of the benefit derived from real estate relative to inflation comes from increasing income and valuations. Markets in which supply outpaces demand, either through excess new development or lack of demand, erode this benefit. As a result, property types with significant supply constraints are beneficial to include in a portfolio. Chestnut’s portfolio is heavily weighted toward medical outpatient buildings, a property type with significant supply constraints. 

Lease term and resetting rents: A balance between properties with long term leases in place and those with shorter leasing results in a portfolio with secure and increasing cash flow through contractual rents but with the ability to increase rents on new leases as they expire. For example, the demand for multifamily investments is predicated on several factors, one of which being the ability to regularly increase rents as demand increases. In short, long term leases provide downside protection while short term leases create the opportunity to increase rents in response to market conditions. The flip side to this dynamic is that if demand weakens then properties with short term leases may see faster income loss as leases expire. Chestnut has tended to prefer property types with longer leases.  

Virtuous cycle of cap rate compression: Because real estate is often viewed as an inflation hedge, investor interest can increase during inflationary periods. Increased investor appetite serves to potentially decrease the spread between cap rates and the 10-year US Treasury yield, a proxy for the relative risk of real estate. This spread has historically been 250 basis points but can be less during times when real estate is viewed favorably on a relative basis. What this means is that real estate values can benefit with cap rate compression even during inflationary periods because of investor demand.  

Financing Costs: Interest rate increases that come about as a result of inflation make financing property investment more expensive, perhaps reducing the leveraged return on investment. To the extent that increased rates are in response to robust economic growth, property owners may have the opportunity to increase rents enough to offset increased financing costs. But in cases where increased financing costs are the result of lender reluctance to lend due to perceived repayment risk, the value of real estate as an inflation hedge will be less pronounced.  

Is real estate an inflation hedge? It depends! 

While there are clear benefits to real estate as part of an investment portfolio during inflation periods, our view is that the benefit depends on many factors including the property type and markets in which an investor is invested along with the general economic conditions. Real estate’s value as it relates to inflation seems to be most pronounced when inflation occurs during times of economic expansion as property performance and value tend to benefit from strong economic conditions, perhaps offsetting the erosive power of inflation and the impact of higher interest rates.  

Sources  

Association for International Real Estate Investors (AFIRE). (July 15, 2021) Revisiting Inflation.  

Federal Reserve. (March 16, 2022) Implementation Note Issued March 16, 2022.  

National Public Radio. (December 28, 2021) Americans Saved a Lot of Money this Year Despite Record Inflation. 

Millionacres. (October 13, 2021) Millionacres Research Report: Cap Rates and Interest Rates: What's the Correlation? 

Wall Street Journal. (February 10, 2022) U.S. Inflation Rate Accelerates to a 40-Year High of 7.5%.  

The Washington Post. (January 15, 2022) Omicron Fallout and Tough Labor Talks likely to Rattle Supply Chains and Fuel Inflation.  

The White House. (April 21, 2021) Pandemic Prices: Assessing Inflation in the Months and Years Ahead. 

Wall Street Journal (February 22, 2022) Commercial Real Estate Is Seen as an Inflation Hedge, but That Isn’t Always the Case 

The information contained in this newsletter is intended for informational purposes only and is not intended to provide personalized investment advice or to constitute an offer or solicitation to buy or sell securities or interests in any investment. The charts, graphs, and other information contained herein should not serve as the sole determining factor for making investment decisions.

This newsletter cannot be reproduced, shared, or published in any manner without the prior written consent of Chestnut Funds (“Chestnut”). Unless otherwise indicated, all statements and expressions in this paper are the sole opinion of Chestnut and are subject to change without notice. Predictions, forecasts, or outlooks described or implied are forward-looking statements based on certain assumptions, which may prove to be wrong, and/or other events, which were not taken into account, may occur. Any predictions, forecasts, outlooks, opinions, or assumptions should not be construed to be indicative of actual events, which will occur. The opinions and data in this newsletter have been obtained from sources believed to be reliable. Chestnut does not warrant the accuracy or completeness of such and accepts no liability for any direct or consequential losses arising from its use.

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