These days everyone is worried about inflation, as it has risen to levels not seen in decades. At auctions, we’ve been seeing price wars erupt on everything from raw land to commercial buildings. But does the popular acceptance of “real estate” as a hedge against inflation really hold water?
The basic hypothesis is that real estate should be a great haven during high inflationary times because it uniquely combines increasing income, appreciating value, and depreciating debt. Plus, one gets an added bump from the “psychology of the crowd.”
As many leases have rent increases and cost escalations anchored to the Consumer Price Index (CPI or) other inflation indexes, the underlying income of a property that drives cap rate determinations tends to rise with overall increases in inflation.
Increases in raw materials drive up new construction costs which in turn restricts the supply of new building projects. This benefits property owners because they can expect less competition from new properties coming on the market and prices are driven upward. This pressure is only compounded in a growing economy that has a high demand for industrial, multifamily, retail, and other spaces. The value of real estate then begins to reflect its replacement cost, which is a direct depiction of inflation in the market.
Inverse to the appreciating value of a property, the amount of debt owed can decrease in value with the rate of inflation; meaning the higher the inflation, the less real value the debt owed has, given a fixed interest rate.
Because real estate has a reputation as an inflation-proof investment, more people buy it simply because they think others will too.
To test the “real estate as a hedge” hypothesis, I attempted to find some empirical data and came across an article published by MIT’s Real Estate Institute. It examines this question using nation-wide data from NCREIF (the National Council of Real Estate Investment Fiduciaries) for each of the four major property types:
The study makes it clear that not all real estate has the same inflation-proof characteristics, and a more nuanced approach is required.
The study observes two variables over a 38 year period:
This was then compared to the CPI index (as a measure of inflation). They statistically calculated how each of these two real estate variables have moved in percentage terms with a percentage change in the CPI. The results show a very mixed and somewhat discouraging picture for those relying on the sector for protection against inflation:
Real Estate CPI Elasticities
The first and most obvious observation is that looking at Income alone, only Retail property income keeps up with inflation (1.02). Industrial (.70) and Apartment (.56) income provide a partial hedge, while Office property income provides virtually no inflation hedge (.18). Of course, every cycle is different, and buyers of Retail properties should note that while Retail rents have traditionally kept up with inflation; the longer term structural trends are against Retail tenants. The sector has been devastated, and landlords may have issues implementing the types of income escalation traditionally seen in this sector.
When looking at total returns, one must also look at property Values as well, and here, predictably, real estate has done better historically as an inflation hedge. Retail and Apartment properties were real inflation hedges (1.07, .98), with Industrial fairly close (.91). Office, again, is the worst, but at least partially keeps up with the CPI (.74).
One peculiarity to note is that for every property type, the property Value grows more significantly than Income over time. The explanation for these different growth rates that is provided by the study’s author is due to the long term secular downward trend in real estate cap rates over the years. These have at least partially matched the widely recognized secular decline in interest rates. With this decline in mind (or rather factored out), he concludes that Values have been better at keeping up with Inflation – despite the fact that Income has not.
Looking ahead – if Income grows as it has in the past (generally less than Inflation), and rising interest rates push cap rates up rather than down (the way they had during the decades which the study looks at), then it’s quite possible there will be little or no future appreciation in real estate assets. Though, as we can see from the table, this may be more true for certain property types than others.
So before plunging into a real estate investment (and bidding without hesitation at the next auction), take a moment to reflect on the fundamental characteristics of a particular property, and don’t assume real estate is the inflation-protected investment you are looking for.
©2022. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.
Joshua Olshin is a Founder & Managing Partner of AuctionAdvisors. He has extensive experience as an auctioneer/liquidator, advising on the auction and disposition of real estate and real estate related assets for over 17 years. In recent years, his expertise has also extended to the marketing and sale of small businesses, minority ownership interests and…
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