Commercial real estate is often considered an inflation hedge, but does this hold through varying market conditions? Many academic studies have sought to provide definitive answers, and most concluded that commercial real estate is an effective hedge against inflation. However, one factor that is often overlooked is the state of the real estate market prior to the onset of elevated inflation. While real estate attributes can mitigate the effects of inflation, the initial conditions of a real estate market influence the effectiveness of commercial real estate as an inflation hedge.
There are several indexes that measure inflation, the most common of which is the consumer price index for urban areas (CPI-U) tallied by the Bureau of Labor Statistics (BLS). CPI-U is often used as a basis for transactions, sometimes referred to as indexing for inflation, as well as social security payments. Since 1950, the annual change in CPI-U, or annual inflation, averaged 3.5%. The year-over-year change reached a peak of 13.5% in 1980 and a low of -0.4% in 2009. In 2021, inflation increased by 4.7% and in recent months of 2022, the year-over-year rate of change approached double-digits. In comparison, the recent year-over-year peak of 9.1% in July 2022 was much lower than the 14.8% peak in March 1980.
The last period of elevated and persistent inflation in modern times was roughly between 1978 and 1982. During this five-year period, the CPI-U grew on average by 9.8% per year. Utilizing National Council of Real Estate Investment Fiduciaries (NCREIF) Property Index (NPI) returns as a proxy for overall real estate performance, the NPI index appreciated by 16.1% per year, outpacing inflation. The ability of real estate leases to adjust for higher costs helped enable real estate to outperform other asset classes.
Interestingly, during the 1978-1982 period, which included the 1980-1982 recessions, real estate returns outperformed even as tenant occupancy levels fell. The vacancy rate increased from relatively low levels through 1982, in some ways like the recent increase in office vacancy rates from historic lows to moderate levels even though the economy is not currently in a recession.
Of course, the “real” nature of real estate as a hard asset is key to the inflation hedging characteristics. The underlying land should, over time, appreciate. This holds true when utilization of land, which may be measured by population density and economic activity, is also growing. It would make intuitive sense that in a city where demographic growth is leading to greater land-use density and economic activity that the implied value of land should increase. In addition to the land value, the value of the structure can lead to appreciation of capital. With many buildings valued in relation to a replacement cost, the higher cost to replace a building also influences the perceived value of an existing property. As construction is a fairly labor intensive process involving specific materials at a fixed location, these costs can be substantially influenced by accelerated rates of inflation. The last two years have exhibited this clearly, as labor shortages and supply chain disruptions led to material delays, the cost to construct any type of building is much higher than pre-pandemic.
The impact of inflation on rents is dependent upon the initial conditions of the real estate market. Rent increases and declines are generally non-linear, that is surges typically occur when the supply/demand imbalance is great. In an extremely tight space market, take the current apartment market as an example, rent increases are often substantial. Conversely, if a market is flooded with supply, rents will not decline slowly but will often fall dramatically.
In terms of the inflation hedging characteristics, the ability for landlords to pass-through expenses to tenants as well as increase base rent is key. Variations in lease structure constrain some pass-through ability. With shorter duration leases, there is more opportunity to pass-through increased expense costs. Hotels, for example, may be considered one-night leases where the room rate can change nightly whereas a 10-year office lease term may have less ability to adjust for unexpected expense inflation. In either case, a rent increase can only be successful if there is sufficient tenant demand.
The ability of a real estate asset as an inflation hedge is therefore less effective during a period of excess supply, or severely reduced demand. Prior to the onset of the inflationary period, higher than average vacancy rates would imply limited effectiveness of real estate as an inflation hedge. In this case, rent increases may fall short of the pace of inflation or rents may decline. If demand and supply are in relative equilibrium, rent growth typically keeps pace with inflation. During periods of strong tenant demand indicated by low vacancy rates, and in particular when rent growth is non-linear, commercial real estate can be an excellent inflation hedge.
The current relatively low vacancy rate, particularly in the apartment and industrial property sectors, highlight the strong potential for commercial real estate to perform as an inflation hedge in the near term. While the pandemic and ensuing recovery provide some distortion to typical supply/demand dynamics, tenant demand is relatively strong in most segments of commercial real estate. Aside from the office sector and some segments of retail, rent growth remains relatively strong and outpacing inflation. Property sectors with shorter lease lengths, such as apartments and hotels, should also provide strong hedging properties during this period of elevated inflation. Strong underlying tenant demand combined with an ability to pass-through expenses or adjust lease rates are key to the effectiveness of commercial real estate as an inflation hedge.
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