March 18, 2022 | Erik Sherman | GlobeSt.com<\/p>\n
Inflation continues to soar and investors\u2014from the consumer\/retail level to the biggest family office, investment, public pension, and sovereign wealth funds\u2014are on the hunt for hedging.<\/p>\n
Commercial real estate has long been seen as a natural inflation hedge, but automatic assumptions need some reconsideration.<\/p>\n
\u201cIt has been decades since we have seen an extended period of high inflation,\u201d Drew Thornfeldt, managing director and global head of real estate investment banking at Chatham, tells GlobeSt.com. \u201cSince that time, the real estate market has changed dramatically\u2014shifting to a global institutional asset class. Data for real assets typically lags other asset classes, and since there have only been a few quarters of elevated inflation, it is challenging to draw decisive conclusions on real estate\u2019s effectiveness to hedge inflation in general.\u201d<\/p>\n
Thornfeldt goes on to note that, anecdotally, both \u201ccash flow and valuation growth in institutional real estate has been strong and would indicate segments of the real estate market effectively provide direct exposure to inflation.\u201d But there\u2019s also a danger in assuming everything CRE will necessarily act the same.<\/p>\n
That\u2019s the conclusion a new analysis by Avison Young comes to, as the firm expects \u201ca period of higher inflation and interest rates than we have been used to in recent years.\u201d Pressures from labor and skills shortages, increases in wages, ongoing if moderated supply chain disruptions, and capacity constraints will continue to fuel inflation that will peak in Q2 of 2022 but still remain above the 2% target of central bankers until next year.<\/p>\n
In theory, Avison Young notes, real estate should be a good inflation hedge. However, like many theories, what might happen on average doesn\u2019t necessarily hold true in all situations. For example, statistical relationships between total returns and inflation are weak because \u201cthe relationship between property performance and inflation depends on the state of the market as well as the type of inflation involved.\u201d<\/p>\n
For CRE to act as a credible general inflation hedge, investment times should be across longer terms and not necessarily as a short-term tool. \u201cTo guarantee positive real returns over their hold period, over the last 35 years office investors should have targeted a 9-year investment horizon for the UK, 10-year for Canada and 13-year for the US,\u201d the report says.<\/p>\n
The company also says that in the type of short-term inflation over the next few years, there are some sectors that work better. Short-term leases; multifamily, student, and industrial; and triple-net leases.\u00a0<\/p>\n
\u201cReturns from core real estate assets are mainly driven by income (which is more closely linked to inflation) than capital growth (which is vulnerable in a rising interest rate environment),\u201d the company writes. \u201cMoreover, rising construction and labor costs (typical in an inflationary environment) render development activity less financially feasible. As a result, prime centrally located office assets, for example, with state-of-the-art technology and sustainability credentials become scarce and more sought after by investors as well as tenants.\u201d<\/p>\n
Moody\u2019s Analytics also has a view in a new report. The thesis is that while CRE can be a weapon against inflation, some assets are \u201ca double-edged sword.\u201d There has to be enough demand to push rent growth. If cap rates or loan coupons are too tightly priced, that can choke any advantages. Also, the efficacy depends on an overall debt position that may not sufficiently benefit from rent growth and at the same time expose investors to higher than expected losses from refinancing rates.
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