December 2, 2014

The word inflation can send many people into a panic over their investments, but savvy investors have long known that commercial real estate can be one way to mitigate the risk against inflation.

In a white paper she published for TIAA-CREF recently, Martha Peyton, Ph.D., lays out some data that shows the relationship between inflation and commercial real estate investments. Her research shows a stronger correlation between inflation and commercial real estate than other investment classes and concludes that CRE is a solid hedge against inflation concerns, writing:

“Leaving correlation aside, several characteristics of commercial real estate investments contribute to its capacity to provide inflation protection…Most important is the structure of leases, which often includes step-ups in rent over the term of the lease. The most inflation protective step-ups would call for explicit indexation to inflation. Even without step-ups, leases have a specified term calling for a new rent contract upon renewal. If the local property market does not have a supply glut at the time of renewal,the adjustment in rent is, at minimum, likely to catch up to inflation.”

In short, commercial real estate has built-in protection against inflation because the return on investment is tied to rents, and rents are designed to increase periodically. Additional protection against inflation occurs when, Peyton notes, leases pass expenses on to tenants.

National Real Estate Investor magazine contributor David J. Lynn, Ph.D., echoes the idea that CRE rents are a hedge against inflation, writing:

“Fundamentally, the value of real estate is supported by the rental payments it generates. In periods of high inflation, rising wages and profits increase the nominal amount tenants are willing to pay for any given amount of space. Meanwhile, higher construction costs (due to rising labor rates and commodity prices) restrict commercial development. The resulting increase in demand and decrease in supply lift rental rates and cash flows. Even if rents do not respond immediately, inflation-fearing investors typically price future rent increases into current values. Over the long term, CRE prices tend to rise with replacement costs, which are driven by inflation.”

National Real Estate Investor highlighted CRE’s value after major economic crises like the oil bust of the late 70s:

“It certainly proved its worth during the United States’ last major inflation scare, following the oil crisis of the 1970s. From 1979 to 1982, as consumer prices increased 10 percent per year, CRE delivered strong returns averaging 14 percent, while stocks (9 percent) and bonds (6 percent) lost ground on an inflation-adjusted basis.”

Fidelity Investments advises investors to include real assets, such as real estate and financial securities, because these “asset categories have historically tended to hold up relatively well during inflationary climates,” while “most financial assets, including the majority of stocks and bonds, tend to underperform their historical averages during an inflationary environment.”

PIMCO, another investment strategy firm, also recommends real assets, saying they can “potentially enhance portfolio diversification, mitigate inflation risk and provide more stable real (after-inflation) returns.” The firm also notes that inflation is likely to pick up in the near future.

A U.S. News & World Report story highlighted portfolio management company Cohen & Steers and the real assets strategy it launched in 2012 because of the company’s projection that “inflation is destined to move higher due to aggressive global monetary stimulus, growth in emerging markets and barriers to production of key natural and agricultural resources.” One portfolio manager with the firm advised dedicating 10 to 20 percent of a portfolio to “inflation-fighting real assets.”

In addition to the ROI of rent increases, investment professionals note the return from real estate’s property value. Lisa Smith of Investopedia writes:

“Real estate is a popular choice not only because rising prices increase the resale value of the property over time, but because real estate can also be used to generate rental income. Just as the value of the property rises with inflation, the amount tenants pay in rent can be increased over time, enabling the income generated by an investment property to keep pace with the general rise in prices across the economy.”

In summary, many experts agree that real assets like commercial real estate are a valuable addition to a sound investment strategy to help mitigate the effects of inflation. Property values and rents tend to rise as inflation rises, while other investments like bonds remain fixed. As the possibility of inflation becomes more likely, the wise investor will consider diversifying with inflation-hedging investments.

Thanks for reading our latest newlsetter. If you are interested in learning about PointOne Holdings’ most recent real estate investment opportunities, please do not hesitate to contact us at your convenience.

Sincerely,

PointOne Holdings