Throughout the course of the past year, investors and financial advisors have intensified their search for ways to mitigate the impact of rising inflation. This search often leads to hard assets like silver and gold or real estate. To help investors in commercial real estate (CRE) select the right assets for their portfolios, our team created an inflation hedge spectrum organizing CRE asset classes in terms of the potential degree of protection they may offer against inflation.
The Value of Hard Assets: Research Highlights
Historically, owning hard assets has served as a hedge during above-average inflation.
To test the relationship between CRE performance and inflation, researchers at Principal created a hypothetical portfolio consisting of stocks, bonds, REITs, and private real estate in the U.S. and UK. The researchers measured performance over seven-year periods using 5,000 random starting points. For the U.S., the data covered the 1978-2020 period. For the UK, the date range was 1987-2020.1
The simulation found that, in the U.S., an index of real estate returns exceeded inflation nearly 91% of the time. For the portfolios that outperformed, the excess over inflation was approximately 667 basis points. The results were similar in the UK, and similar findings emerged in a study by Clarion Partners which found that, since 1994, commercial real estate rents outpaced inflation in 19 of the 27 years (i.e. 70%).2
Mark-to-Market Rents: A Key Factor in Inflation Resiliency
Even if CRE, in general, continues to mitigate the effects of inflation, the industry encompasses asset classes whose inflation resiliency can vary widely, mainly depending on the adjustability of rents to market rates. We organized the main CRE asset classes along an inflation hedge spectrum. In strong and moderate-resiliency assets, owners can adjust rents and help mitigate the effects of inflation. In the low-resiliency category, the effects of inflation may be more pronounced due to contractual limits on rent adjustments.
CrowdStreet’s Inflation Hedge Spectrum by Asset Type from Strongest to Weakest
Generally, we believe the more leverage an asset class holds to adjust the net operating income generated from the property during high inflationary periods, the stronger the hedge it offers against the erosion of real returns. While leverage has potential benefits, it can also bring significant financing risks. Please keep in mind this is for illustrative purposes and is subject to change. Past performance is not indicative of future performance.
Strong Inflation Resiliency
We believe the highest end of the spectrum includes assets whose owners can quickly adjust rents to inflation. So, hotels and multifamily arguably stand at the top of the stack. For hotels, rental rates are marked to market daily, but multifamily is usually more institutionally favored with enough units rolling over month-to-month for net operating income (NOI) growth to outpace inflation.
Moderate Inflation Resiliency
In the mid-range of the spectrum, we place industrial and multi-tenant office assets. In these properties, usually, no single tenant occupies more than 20% of the building, and most tenants are on 3-5 year leases. This is a fluid category since many office tenants are reducing the length of their lease terms, in part due to the uncertainty stemming from the emerging WFH culture.
This category is also affected by the growing popularity of coworking spaces. Among the managers of these properties, some (e.g., Industrious) are better prepared for rising inflation because their subscriptions are marked to market monthly. By contrast, the business model of managers like WeWork (i.e., lease long-term and sublet short-term) is better for WeWork than for landlords who have already locked up their rent bumps with the coworking master tenant.
Weak Inflation Resiliency
On the opposite end of the spectrum are 100% triple-net (NNN) long-term leased assets. An example of this type of asset would be a Starbucks, or Walgreens, or a single-tenant industrial space leased to Amazon. The NNN aspect of the leases provides some buffer against inflation, but the predetermined annual rent bumps of typically 2%-3% may fall short of the inflation rate. During any period where inflation exceeds these rental increase rates, owners and investors could lose from a real-return standpoint. However, “weak” inflation resiliency doesn’t typically mean zero resiliency. For example, some NNN leases are pegged to the Consumer Price Index (CPI), adding in rent bumps as CPI increases.
Conclusion
Investors can help mitigate the effects of inflation by investing in CRE and selecting assets that can more readily adjust rents as inflation increases.
To learn more, please visit www.crowdstreetadvisors.com.
Endnotes
- Source: Principal, “Real estate’s role as an inflation hedge in a post-COVID world” Published 2021
- Source: Clarion Partners “Commercial Real Estate and Inflation Resistant Income” Published October 20, 2021
Disclosure
This article was written by an employee of CrowdStreet and has been prepared solely for informational purposes. All information is from sources believed to be reliable. Nothing herein should be construed as an offer, recommendation, or solicitation to buy or sell any security or investment product issued by CrowdStreet or otherwise. This article is not intended to be relied upon as advice to investors or potential investors and does not take into account the investment objectives, financial situation or needs of any investor. Investing in commercial real estate entails substantive risk. You should not invest unless you can sustain the risk of loss of capital, including the risk of total loss of capital. All investors should consider their individual factors in consultation with a professional advisor of their choosing when deciding if an investment is appropriate.
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