Maybe CRE Isn't the Inflation Hedge It's Reputed to Be

Amid global inflation spikes, institutional investors have been flocking to commercial real estate en masse—but one expert urges a slow hand, noting that “real estate can outperform inflation, but not always.”

Real Capital Analytics’ Jim Costello notes in a new analysis that in the G20 countries alone, inflation hit 4.6% through September, outpacing its pre-pandemic rate. But “inflation can distort investment decisions,” he says. 

“Rather than focusing on the fundamentals of a project, inflation can lead investors to underwrite above-average income growth,” Costello says. “It might work for a while, but over the longer term, the accompanying increase in interest rates can reduce financing options and push up cap rates thus hurting valuations.”

He acknowledges that analysis of inflation trends against commercial real estate performance is challenging since detailed data collection typically only dates back to the 1980s, after the global inflation crisis of the decade prior.

But the consumer price indices generated by governments captures a valuable variable, he says: the records of rental prices paid in residential markets over time. While imperfect metrics, Costello says residential rents provide a long-term view of income performance.

In the US, UK, Japan, and Australia, according to RCA data, residential rents have outperformed inflation by 40 basis points over the last 25 years. The US outperformed, while Japan underperformed—a difference Costello says is likely because fewer housing units are built relative to population size in the former than in the latter.

“Investors are currently hungry for long duration assets with an inflation hedge. There are times when real estate has provided such a hedge, other times, not so much,” Costello says. “Investors should not assume that all real estate is protected from inflation, if the market cycles of tenant demand and new supply are working against one’s investments, inflation is not likely to help paper over any mistakes in underwriting.”

Another view on the subject comes from Marcus & Millichap’s John Chang, who recently took a sunny view of CRE as an inflation hedge in the US property markets, noting that interest rates are expected to rise in the next six months in part from the Federal Reserve tapering of Treasury and mortgage-backed securities purchases. He says quarter commercial real estate volume is up 19% compared to the third quarter in 2019, and predicts that the rise in rates isn’t expected to lower CRE volume as there’s much capital looking for yield.